IRS STUDY GROUP ISSUES WORKING DRAFT CHAPTERS OF STUDY ON CIVIL TAX PENALTIES.

The study group suggests that penalties be designed to encourage a standard of behavior and to deter noncompliance. They say that penalties should conform to criteria of fairness, effectiveness, comprehensibility, and administrability. The group suggests three principal accuracy penalties: a negligence penalty that would apply if a taxpayer took a position on a return that was not more likely than not to prevail and if the taxpayer took the position intentionally or without reasonable care; a gross negligence penalty to apply if the taxpayer's position did not have a realistic possibility of success and the position was taken intentionally or without reasonable care; and, a fraud penalty similar to the existing penalty. Most other accuracy penalties would be repealed.

PURPOSE:

This topic will cover selected working draft chapters (1-4 & 8) and the recommendations contained therein.

TOPIC PRESENTERS:

                                   IRS                 CAG

Dick Stark, Assistant to the Commissioner, and Jack Carlson, the CAG's Penalty Sub-Group focal point, will open the discussion with the summary and highlights of the Report on Civil Tax Penalties by the Executive Task Force of the Commissioner's Penalty Study. The two will then entertain discussion of the recommendations contained in the draft Study Report.

PENALTIES

EXECUTIVE SUMMARY

For the last year, the Commissioner's Penalty Study Task Force has been examining the civil penalty structure as well as a selected number of specific civil penalties. The Task Force has developed a comprehensive philosophy on penalties (Chapter 4) against which to evaluate the efficacy of individual penalties and civil penalties as a whole.

The Study Group believes that civil penalties ought to be designed around a standard of behavior and should function in a manner to encourage that behavior and deter noncompliance. Further, they have identified the four criteria of FAIRNESS, EFFECTIVENESS, COMPREHENSIBILITY, AND ADMINISTRABILITY against which to measure whether particular penalties conform to the desirable penalty philosophy and are positively impacting voluntary compliance.

Chapter 8 examines the penalties encouraging taxpayers to make accurate reports to the IRS. It takes the position that taxpayers should be expected to try to file accurate returns with IRS. It defines "trying" as exercising reasonable care (a negligence standard) and an "accurate" return as one in which each position is either disclosed or is more likely than not to prevail if challenged.

The Chapter proposes that three principal accuracy penalties be used to support this standard:

1. A negligence penalty that would apply if the taxpayer took an undisclosed position on a return that was not more likely than not to prevail AND the taxpayer took such position either intentionally or failed to exercise reasonable care in taking such position.

2. A gross negligence penalty that would apply if the taxpayer took a position on as return that did not have at least a realistic possibility of success of prevailing if challenged AND the taxpayer took the position either intentionally or failed to exercise reasonable care in taking it.

3. A fraud penalty similar to the existing penalty.

The penalties would be coordinated as set forth in the recommendations beginning on page 32 of chapter 8. Most other accuracy penalties, including the substantial understatement penalty and the valuation penalties would be repealed. As described in more detail in the recommendations, the preparer penalties and Circular 230 would be revised to reflect the standard of behavior suggested.

WORKING DRAFT, CHAPTERS 1-4, 8

INTRODUCTION

I. NEED FOR THE STUDY.

As long ago as 1975, reports on penalties were referencing the "mind-numbing assortment of civil penalties." At that time, 64 were counted, ¹ Today, with the number of penalties approaching 150, the absence of a systematic approach to the enactment, assertion, and abatement of penalties is a serious problem. This report of the Commissioner's Penalty Study attempts to set forth, from the perspective of the administrator, the underlying reasons for penalties, a way of evaluating them, goals for their administration, an evaluation of the existing penalties, and recommendations for improvement.

The proposition that penalties should be investigated and evaluated as a system is a somewhat original idea in tax administration. It runs counter to the everyday experiences of practitioners, administrators, legislators, and taxpayers, who for the most part encounter penalties only occasionally, Yet this absence of a unified approach can lead to the use of penalties for inappropriate purposes and prevents cogent arguments against such uses. Additionally, the absence of a systematic approach encourages views of penalties as a panacea for all compliance problems, with increases in severity substituting for more thoughtful attempts to solve existing compliance problems. Most importantly, the lack of systematic application of penalties undermines the perception of fairness that is important to sustain compliance. The Task Force believes that an overall philosophical perspective is essential. Only with such a viewpoint could the study go beyond the analysis of isolated problems to a more meaningful assessment of the place of penalties in tax administration and the development of guides to the enactment and use of penalties in the future. IRS has a unique perspective on penalties because they are primarily an administrative tool. Thus, the Task Force has developed its thoughts based on what system would most effectively support our tax system within the context of a just and democratic society.

II. SCOPE OF STUDY.

The study covers those penalties set forth in Subtitle F, Chapter 68 of the Internal Revenue Code of 1986 (sections 6651 through 6724) and other provisions of the Code having similar characteristics. Generally, these provisions specify an amount that must be paid if certain conditions of noncompliance exist. For example, the negligence penalty of section 6653(a) provides for the computation of a sum payable if an underpayment exists and the underpayment is due to negligence or disregard of rules or regulations. The section sets forth the calculation of the amount due. The required conditions for imposing the penalty are further defined by regulation, ruling, and case law. These characteristics of Section 6653(a) are similar to those of most other sections in chapter 68. The Random House Dictionary of the English Language defines a penalty as "a punishment imposed or incurred for a violation of law or rule." This definition accords with the operation of the chapter 68 penalties, for each is imposed only as a consequence of the violation or nonfulfillment of conditions that are also stated.

Based on a consideration of these authorities and the objectives of the study, the Task Force defined a "penalty" as follows:

an adverse consequence that may be imposed on a person for failure to comply with a federal tax rule.

The Task Force, however, felt that this broad definition includes a number of provisions in the tax law that should be excluded from the scope of this study. After examining the full potential scope of the "adverse consequences" that might be imposed on taxpayers for failure to comply with tax rules, the Task Force limited the study to a subset of tax penalties, and defined this subset as follows:

civil monetary penalties, exclusive of regular interest charges.

Other penalties, such as criminal sanctions and benefit disallowances, and other costs of noncompliance, such as regular interest charges, may deserve study. However, peripheral conceptual issues would have been raised by including such items and would have detracted from the Task Force's focus on the more general principles suggested below.

Some of the specific items or issues that are excluded, and the reasons for their exclusion, are as follows:

1. Compliance Contacts. Many taxpayers view any audit or notice as a penalty because such a contact can have an emotional or economic impact on a taxpayer. While such contacts do serve a compliance purpose, their intent is not to impose a sanction for noncompliant behavior. Accordingly, the Task Force has excluded such contacts from the scope of the study. Contacts that incorrectly assert a penalty, however, are an important consideration in the study. Additionally, the report does not discuss the issue of how best to detect violations of the tax laws. The detection process is important for penalties to work, but it encompasses a variety of compliance concerns and needs that are much broader than penalty issues.

2. Criminal Sanctions. The Task Force excluded criminal sanctions from the study because they raise issues (such as the quality of proof and procedural protections) that civil penalties do not, because the principal concerns voiced today revolve around the civil sanctions, and because they are not under the full jurisdiction of IRS. However, the approach of the study might assist a later study of criminal sanctions.

3. Loss of Benefits. The Task Force generally excluded losses of benefits such as the disallowance of deductions for a nonresident alien who fails to file a timely return, the disallowance of an accounting method to one who fails to file an election, or the imposition of backup withholding. While the Task Force views such benefit disallowances as penalties, except in the area of employee plans and exempt organizations, we have not focused our work in this area. In many instances, benefit disallowances are not imposed because a rule has been violated -- oftentimes the taxpayer has a choice among compliant behaviors and elects one. In other instances, the purpose of the benefit disallowance is to impose a sanction on noncompliant behavior. Rather than analyze all possibilities, the Task Force felt that, initially, the greatest contribution it could make was to provide an analytical framework for the purpose of evaluating such quasi-penalties and that this framework could most easily be established by focusing only on those penalties that affirmatively and directly impose a fine.

4. Basic Interest Charges. The Task Force excluded the basic interest charged on deficiencies from the study. To the extent that the interest rate reflects what the government would have earned on timely deposited funds, interest does not constitute a penalty. To the extent, however, that the interest rate is higher, it might arguably be viewed as a penalty. Rather than debate the present purpose of basic interest charges and their nondeductibility, the Task Force has excluded them from the study. However, other charges calculated using time-value concepts, including the 120 percent tax- motivated interest rate, clearly fall within the scope of the study.

III. ANALYTICAL APPROACH.

The Task Force reviewed penalties, as defined above, with the objective of developing a systematic approach to both the design of penalties and to the administration of such designs. The initial phase of the study was the collection of information. In addition to collecting currently available statistics and written materials, the Task Force commissioned a series of focus groups for the purpose of hearing first-hand current comments and reactions to penalties. The results of these focus groups were summarized in a report issued in August. Finally, comments that were requested from the IRS's field organization were received and reviewed.

The systematic approach of the study was developed after a review of these materials primarily through discussion and analysis of administrative objectives. This approach is set forth in chapters 2-4. Chapter 5 is a history of civil tax penalties and the administration of them. Chapters 6-9 use the philosophy to analyze the design of existing penalties and recommend improvements. In these chapters, we group the penalties according to the type of behavior that they are designed to protect and encourage. We then analyze the penalties in each group in terms of how well they accomplish this objective. Chapter 10 applies the philosophy of administration to assess the job IRS is currently doing and recommend improvement. It focuses on three major issues: the scope of discretion, the education of taxpayers, the assertion of penalties and evaluation of penalty programs.

CHAPTER 2

THE PURPOSE OF CIVIL TAX PENALTIES

I. ENCOURAGING VOLUNTARY COMPLIANCE

Taxpayers in the United States assess their tax liabilities against themselves and pay these liabilities voluntarily. We call this system of assessment and collection a self-assessment system, based on the principle of voluntary compliance. The term "voluntary compliance" is sometimes misinterpreted to suggest that a taxpayer can choose to comply or not, as he or she wishes. Of course, this is incorrect. Once the country as a whole agrees through the political process to levy and collect a tax, the tax itself becomes an enforced exaction from the populace and the willful failure to self-assess and pay over these taxes is a criminal offense. Voluntary compliance means merely that the citizens and other taxpayers of the country do voluntarily, and without direct compulsion from the tax administrator, that which they are required by law to do.

Why collect taxes based on principles of voluntary compliance? One reason is that it is efficient. The alternative, which would probably be some sort of canvassing and collection by tax collectors, is simply not feasible without a great increase in the expenditures devoted to administering the tax system. Another reason is that the determination of liability may on the whole be more accurate. The taxpayer is in the best position to determine accurately the taxes due, since the taxpayer is the one that has the best knowledge of his own financial situation and has the best access to needed facts. A third reason is that a system based on voluntary compliance is less intrusive and less adversarial than the alternatives. Even with the comparatively low incidence of audits and collection cases present in the tax system today, the level of controversy and adversariness present in these cases suggests that minimizing such situations, to the extent consistent with voluntary compliance, is highly desirable. Finally, the concept of voluntary compliance is in part based on taxpayers' recognition that they have a civic duty to participate in defraying the costs of government; the general recognition of this duty by taxpayers and the positive attitude toward self-assessment probably has a powerful positive impact on the percentage of tax liability that is actually collected.

To self-assess one's tax liability and voluntarily pay it, a taxpayer must know the rules that he or she should follow in assessing and paying the liability. As a practical matter, this requires written materials providing an explanation of the rules and forms that permit the self-computation of tax liability. In addition, there must be a way of paying the liability to the government. This requires the ability of the government to cash a taxpayer's check. The government also must be able to keep an account for the taxpayer and make appropriate debits and credits to it and must be able to protect this system of voluntary compliance.

The Internal Revenue Service is the agency charged with these duties. It has set out its mission formally as follows.

MISSION

The purpose of the IRS is to collect the proper amount of tax revenues at the least cost to the public, and in a manner that warrants the highest degree of public confidence in our integrity, efficiency and fairness. To achieve that purpose, we will:

Encourage and achieve the highest possible degree of voluntary compliance in accordance with the tax law and regulations;

Given the wide-ranging responsibilities of the IRS and the ultimate reliance of our taxation system on voluntary compliance, penalties have a relatively limited, though important role. The compliance function of IRS is principally concerned with protecting and enhancing voluntarily compliant conduct by taxpayers. Penalties constitute one important tool for IRS to use in pursuing its mission of encouraging voluntary compliance. In line with IRS's mission, IRS believes that penalties are positively related to the accomplishment of IRS's mission only if they operate to encourage voluntary compliance, and that penalties can and should be evaluated solely on the basis of whether they do the best possible job of encouraging compliant conduct.

II. OTHER PURPOSES REJECTED

While the Task Force believes that penalties should exist to support voluntary compliance and be evaluated solely on that basis, other possible purposes for civil tax penalties have been advanced. These possibilities include (1) the raising of revenues, (2) punishing noncompliant behavior, and (3) reimbursing the government for the cost of compliance programs. There is no inherent reason that penalties cannot be used for any of these purposes. All of these purposes are sometimes consistent with compliance objectives. However, the Task Force rejected these purposes because it believes that penalties should be rationally related to the standards of behavior protected by the penalties and that penalties best aid voluntary compliance if they foster positive beliefs in the fairness and effectiveness of the tax system. These positive beliefs encourage compliance in areas that cannot be reached through audits, penalties, or other programs.

Using penalties to raise revenues directly through penalty receipts confuses the different roles of substantive tax rules and penalties. Of course, penalties raise revenues collaterally. But as an independent objective, revenue raising is not rationally related to compliance objectives. The absence of this rational relationship can be shown by postulating a penalty, such as the negligence penalty. that increases in proportion to the tax avoided. If a 1% increase in the penalty rate induced an increase in compliance greater than 1%, penalty receipts would actually decline. Yet for any penalty rate less than 100%, total tax and penalty receipts would increase. This example demonstrates the pitfall of treating penalties as a revenue source rather than an instrument for increasing voluntary compliance.

If a penalty is used for the primary purpose of raising revenues, it has aspects not only of a penalty but of a substantive tax rule itself and perhaps is best addressed by splitting its role in two -- the portion that is properly related to its role in enhancing compliance and the portion that is really a substantive revenue-raising measure. The portion that serves the primary purpose of raising revenues can then be examined based on the policies and approaches used to evaluate all substantive tax rules. Although the Task Force has not examined the policies used in the passage of substantive tax rules, the Task Force believes that the use of penalties for the purpose of raising revenues is inconsistent with the standards for passage of substantive tax rules.

Clearly, penalties operate by punishing noncompliance. But this is a mechanism by which the goal of encouraging voluntary compliance is achieved and is not a goal in and of itself. The use of penalties to punish tax offenders is consistent with enhancing voluntary compliance only if the punishment itself is necessary to assure both compliant and noncompliant taxpayers of the social value of compliance. If penalties become too severe, they may have penal aspects that are more appropriately dealt with in the context of criminal sanctions. The ultimate penalty for a tax offense -- imprisonment -- is not, and should not be, a civil matter. Only criminal constitutional protections are sufficient to protect the rights of the accused when such potentially severe penalties are involved.

If the severity of a civil penalty exceeds the severity that is appropriate in a civil context, it may have an adverse impact on taxpayer attitudes about the fairness of our self-assessment system. If punishment of noncompliance is ever an independent goal, the criminal sanctions of the Code are the place for such a purpose to be implemented. While punishing noncompliance is not NECESSARILY incompatible with the voluntary compliance purpose of civil penalties, it should not be an independent purpose of civil penalties.

The use of penalties to reimburse the government for the cost of compliance programs also may conflict with enhancing voluntary compliance. While no conflict exists so long as penalties are imposed at such time and in such amount as to support voluntary compliance, the cost of administering a compliance program is not necessarily synchronized with the severity required to obtain maximum compliance -- it may be either too high or too low.

III. THE BEHAVIOR THAT CONSTITUTES VOLUNTARY COMPLIANCE.

Our general definition of a "penalty" as an adverse consequence imposed for violating a federal tax rule takes as a starting point a distinction between the consequence (i.e., the penalty) imposed for violating a rule and the rule itself. This distinction between a rule and the consequence of violating it establishes the fact that penalties operate in the service of a set of other rules or expectations. The identification of the set of rules protected by penalties becomes, then, a critical issue, for each penalty should be evaluated based on its success in protecting or improving compliance with the rule to which it relates.

In section A above, we suggested that a distinction exists between the substantive tax law of the Code and the standards of behavior which, if complied with by a taxpayer, constitute voluntary compliance with the tax laws. A review of the Code shows that most penalties relate to one of a relatively few types of behavior: the filing of returns and mailing of statements; the accuracy of the . information included on those returns and statements, and the payment of tax liabilities. The remaining penalties relate either to the special status of certain entities or to other matters that are collateral to one of the three groupings set forth above.

For most taxpayers, then, voluntary compliance lies in making the requisite effort to prepare returns, file them, and pay any tax liability shown. The efforts to comply expected of taxpayers constitute the standards of behavior that penalties should support and those penalties should be evaluated based on how well they support this standard. The Task Force determined that the definition of those standards of behavior was a necessary first step in assessing penalties. These standards are described in Chapters 6-9, but are mentioned here because a general understanding of the concept is necessary to understand the discussion of evaluative criteria in chapter 3.

IV. SUMMARY.

In summary, penalties exist to support the standards of behavior that taxpayers are expected by the Code to meet, This is synonymous with the use of penalties to encourage voluntary compliance. Penalties should be evaluated based on the extent to which they achieve this purpose. Possible alternative reasons for the existence of penalties, such as the raising of revenue, the punishment of offenders, or reimbursing the government for the costs of enforcement programs are possible consequences of the assertion of penalties but should not be viewed as independent purposes for penalties because they can conflict with the purpose of encouraging voluntary compliance.

CHAPTER 3

HOW PENALTIES ENCOURAGE VOLUNTARY COMPLIANCE

I. THE THREE PROCESSES.

How do penalties encourage voluntary compliance? The social science literature identifies three processes through which penalties can encourage the noncompliant taxpayer to comply, and compliant taxpayers to continue to comply. These are:

(1) The setting and validation of standards of behavior;

(2) Deterring departures from these standards of behavior; and

(3) Providing taxpayers who depart from the standard their just deserts.

A. THE SETTING AND VALIDATION OF STANDARDS OF BEHAVIOR.

In the tax area, standards of behavior generally have their source in the Internal Revenue Code. This statutory basis establishes that citizens as members of the political community supported by taxes, have a duty to comply. A rule that has long been in existence and is relatively uncontroversial may also be supported by the norms, attitudes, and expectations of society as a whole. These statutory and normative supports for a standard of behavior are particularly important -- and perhaps particularly difficult to achieve -- in the tax area. Unlike many other areas of the law in which the social interest in compliance with a behavioral standard is obvious, the importance of a standard in the tax area may be more difficult to identify. Penalties as a consequence of violating a standard of behavior remind taxpayers of their duty.

Some perceived problems with civil tax penalties may really constitute dissatisfaction with the standard of behavior that has been identified, suggesting that the standard itself should be reexamined and modified, rejected, or reaffirmed. Penalties may be a poor way to obtain consensus on a new behavior standard, but a good way to validate and preserve one already established. For example, much of the controversy surrounding the substantial understatement penalty seems to reflect a lack of consensus as to the standard of conduct that a taxpayer should observe in reporting undisclosed items. This issue goes far beyond the existence of this penalty to the question of what the taxpayer's duty should be in completing a tax return.

B. DETERRING THE DEPARTURE FROM STANDARDS OF BEHAVIOR.

Deterrence promotes voluntary compliance by underscoring and validating the importance of these standards, the deterrent function of penalties promotes compliance by posing a threat to those not inclined to recognize any obligation to comply. Deterrence falls into one of two categories: specific deterrence or general deterrence. Specific deterrence is the imposition of an adverse consequence on a particular taxpayer who has violated a standard of behavior for the purpose of causing that taxpayer not to violate that standard in the future. General deterrence is the imposition of an adverse consequence on a taxpayer who has violated a standard for the purpose of causing other taxpayers not to violate it. While civil tax penalties appear to focus on economic costs, other types of costs have historically been recognized and used. In the criminal context, deprivation of liberty, life, and limb have all been used in various cultures. Physical pain -- anything from spanking a child to flogging a sailor -- has also had a role. In a more subtle sense, other costs may have a role. Hester Prynne's scarlet "A" uses the social stigma of disclosure and condemnation by one's peers as a deterrent. Lady Macbeth's guilt over the murder of Duncan destroys her. Whatever the costs imposed by a sanction -- whether economic, social, or moral -- the objective in deterrence theory is not to impose the cost, but rather to cause the sanctioned taxpayer and other taxpayers to comply with the standard.

C. GIVING NONCOMPLIANT TAXPAYERS THEIR JUST DESERTS.

Voluntary compliance is encouraged by establishing and fostering perceptions that our tax system is a fair one, worthy of all taxpayers' support. Given that examination programs and other compliance contacts can touch only a small fraction of the population, these positive attitudes are a major impetus toward accurate self-assessment and voluntary compliance. Such positive attitudes, it is submitted, are best fostered through a system in which both the compliant and noncompliant taxpayer believe that the noncompliant taxpayer who is caught gets his just deserts -- no more and no less. Penalties that punish the noncompliant taxpayer disproportionately are inconsistent with the fundamental principles of fairness upon which our system of government is founded. Thus, a normative reason exists for limiting the size and reach of penalties -- making the penalty fit the crime, so to speak, or giving the noncompliant taxpayer his just deserts.

II. EVALUATING PENALTIES.

If one agrees that penalties should encourage voluntary compliance through the setting and validation of standards of behavior, the deterrence of departures therefrom, and the imposition of just deserts on the noncompliant, then it should be possible to establish a way to evaluate how well penalties do this. Since each penalty is directed at a particular standard of behavior, the initial step in evaluating a penalty is to identify the standard to which it relates. The Task Force found that these standards were sometimes inadequately articulated, ambiguous, or otherwise required further definition. In such cases, the Task Force took on the definitional task and developed the standard that it viewed as most appropriate based on existing laws and the needs of the tax system. The portion of the report dealing with penalty design is organized according to standards relating to (1) the filing of returns, (2) the payment of tax, (3) the accuracy of returns, (4) and certain off-return standards.

The next step was to determine whether the current penalties appropriately supported the standards identified. This question focuses on whether the penalty really affects the way taxpayers behave. Unfortunately, little work has been done in evaluating penalties from an empirical perspective. In the absence of such work, the Task Force developed four criteria -- fairness, administrability, effectiveness, and comprehensibility -- that it believed to be the best indicators of how well a penalty works. The underlying thesis of this study is that a penalty which best reflects the competing needs of these four criteria will appropriately encourage compliance with the standard of behavior to which it relates.

III. THE FOUR CRITERIA.

A. FAIRNESS. Given the limited enforcement resources provided to IRS and the fundamental due process tenets of our governmental system, the voluntariness of compliance is essential. The personal ethics and social norms of taxpayers, as well as the deterrent effects of available enforcement tools, encourage voluntary compliance. These attitudes arise in part from the belief that our system of computing, assessing, and collecting taxes deserves respect and support -- that the system is fair and that each taxpayer is fairly treated. With respect to penalties, fairness encompasses: equity (whether similarly situated taxpayers are treated similarly) and proportionality (whether the penalty in a particular situation is proportional to the seriousness of the departure from the standard of behavior established).

1. EQUITY. A penalty should treat similarly situated taxpayers similarly. This requires a knowledge of facts relevant to noncompliance and a judgment as to whether taxpayers' situations are similar or dissimilar. Among the facts that one might reasonably take into account are past histories of compliance, the aggressiveness of the noncompliance that occurred, how hard the taxpayer tried to comply, the number of instances of noncompliance on any one return, how much the taxpayer can reasonably be expected to understand (perhaps based on the taxpayer's educational level), the standard of behavior that was breached, the general compliance levels of any natural grouping within which the taxpayer might find himself (e.g., should noncompliance in the area of tip reporting be treated differently than instances of noncompliance in reporting interest and dividend income), and the complexity of the required conduct.

Consistent application of a penalty to breaches of a standard of behavior help the standard gain acceptance. If the standard is only intermittently enforced, it loses importance. In some sense, a penalty builds a fence or dividing line between conduct that is okay and conduct that is not okay. Since this dividing line cannot be seen, it becomes important for everyone who flirts with it to find it in the same place.

2. PROPORTIONALITY. Of course, the fact that similarly situated taxpayers are penalized similarly does not necessarily mean that the penalty is fair. Perhaps these taxpayers have all been equally, but unfairly treated. Thus, a penalty should be proportional to the culpability of the noncompliant taxpayer and to the harm caused by the instance of noncompliance.

Making a penalty proportional to the culpability of the taxpayer generally requires an assessment of the extent to which the taxpayer's state of mind or motivation varies from that exhibited by a compliant taxpayer. Whether the taxpayer exhibited a lack of diligence, a fraudulent intent, negligence, or intentional disregard may be relevant in determining the appropriate penalty. On the other hand, a penalty that merely imposes a toll charge on a course of legal but discouraged conduct may not require such an inquiry.

Proportionality also requires that the potential for harm caused by the act of noncompliance be considered. This serves two purposes. First, by providing a sanction that is proportional to the seriousness of the noncompliance, it helps identify and validate the standard breached. Secondly, it gives both the penalized and the unpenalized taxpayer the perception that justice has been done by punishing the person who has violated the standard in proportion to the seriousness of the breach.

Determining the extent of the harm caused by an occurrence of noncompliance may require an inquiry into many different facts, including the amount of any tax that was avoided, the extent of delay in compliance, the proportion of the tax avoided to the taxpayer's correct liability, the effort made to comply with the law, the number of documents with respect to which noncompliance occurred, and whether a filing was omitted or simply delayed.

B. EFFECTIVENESS. A penalty is effective if the costs that it imposes and the method of computation seem likely to deter violations of a standard of behavior both by the taxpayer who is penalized and those who are not. Since the Task Force did not possess the empirical information or analyses to establish as a fact whether particular penalties were "effective," it was limited to the making of judgments as to whether a penalty seemed likely to have maximum effectiveness. Effectiveness as a design criterion has two basic characteristics.

1. ADEQUATE SEVERITY. The aggregate costs imposed on an instance of noncompliance should reflect the benefit to the taxpayer from the noncompliance, given the totality of the circumstances. Whatever the potential benefits from noncompliance are to a taxpayer and whatever the costs imposed by a sanction, the objective is not to impose the cost, but rather to cause the taxpayer to try not to violate the norm. This deterrence objective is the key to measuring the adequacy of a penalty's severity. Increasing severity in a way that is unrelated to this deterrence objective is inappropriate and unnecessary.

Assessing severity may require that costs other than dollars and cents be taken into account. For some people, a social or personal moral stigma may be attached to a penalty. Another perceived cost may be the likelihood of triggering an audit, a matching program, a criminal investigation, or a collection action. On the other hand, noncompliance that does not trigger other costs may require a larger economic penalty even though it may not seem fully justified otherwise. For example, some focus group participants suggested that the requirement to file Forms 1099 on magnetic media has little normative force. In such a case, perhaps the economic aspect of the penalty must be given more weight.

Taking noneconomic costs into consideration may not be particularly effective with taxpayers who have deliberately violated a standard because they may be relatively insensitive to any social or moral stigma associated with the violation. On the other hand, for those who recognize and accept a standard and who violate it through a lack of effort, the symbolic nature of a penalty may be enough to prod them to exercise greater diligence in the future. Finally, for those taxpayers who are compliant because a penalty is an effective general deterrent, appropriate severity of the penalty may be a key to continued compliance.

Appropriate severity may also vary based on the benefit that the taxpayer expects from the noncompliant action. In the case of noncompliance related to the assessment and payment of tax, many penalties are automatically adjusted based on the amount of the tax avoided. This seems appropriate. Preparers generally are subject to much more limited penalties, which perhaps reflects the fact that, unless they are engaged in an ongoing course of noncompliant conduct, the potential benefit to them of noncompliance is limited to fees that they might not otherwise collect. The benefit to information filers from noncompliance, on the other hand, would probably be appropriately calculated based on the resources saved by not instituting an adequate compliance program.

2. ENCOURAGING REMEDIAL ACTION. The second aspect of effectiveness is whether the method of computing a penalty actually encourages the noncompliant taxpayer to take corrective action. For example, a penalty imposed with respect to failure to file information documents should encourage the filing of such documents. A penalty for the failure to make a deposit of withheld taxes should encourage such deposit. If a penalty is directed merely at deterring noncompliant conduct and not at correcting it, its design can be improved. In these two situations, progressively increasing penalties might well encourage compliance more than a system that provides the same penalty regardless of remedial action by the taxpayer. The approaches that can be used to encourage a taxpayer to bring his affairs into compliance include the use of a system of graduated penalties based on any of a number of factors, including the length of time noncompliance continues, the amount of tax avoided, and the taxpayer's history of recidivism.

An alternative approach would be to reward, to some extent, the taking of remedial action. Thus, one could consider some system of discretionary waiver of penalties based on voluntary correction or the holding of a possible penalty assertion in abeyance pending the completion of a period of fully compliant behavior by the taxpayer. Where lack of knowledge is a primary concern, educational obligations might be imposed as an alternative penalty. For example, small businesses with inadequate record systems could be required to take accounting classes that would help them comply in lieu of the assessed penalty. Whatever the approach, the objective is to use the penalties as effectively as possible as a tool for encouraging taxpayers to correct noncompliant behavior.

C. COMPREHENSIBILITY. Penalties need to be both understandable and understood, as do the standards of conduct supported by the penalties. Comprehensibility contributes to all of the voluntary compliance purposes of penalties. Voluntary compliance implicitly requires behavioral standards that are understandable to taxpayers of widely varying education and ability who spend a limited amount of time attempting to understand their tax obligations. Deterrence assumes that a taxpayer understands the probable consequences of a departure from the standard, and principles of just deserts assumes that taxpayers will understand the logic upon which the penalizing of a departure from a standard is based.

Comprehensibility may mean different things for different groupings of taxpayers. The practitioner or the sophisticated financial institution may be able to deal with more complexity than can individual taxpayers, and their affairs may be more complex. Thus, standards of behavior and penalties for sophisticated taxpayers could be more complex than for average taxpayers, reflecting the greater number of problems and issues involved.

Complexity may derive either from the complexity of the standard of behavior involved or from the complexity of the rules governing the imposition and computation of the penalty. For example, the standard for income tax reporting positions -- what should be reported and how one may report uncertain positions on a tax return -- seems very complicated and difficult to grasp. In some sense, this standard, protected by the penalties of sections 6661 and 6653, has been the subject of controversy for years. This question of what the standard should be is distinct from the question of how departures from that standard should be penalized. At present, the rules governing this latter question are also complicated, but this has more to do with how sections 6661 and 6653 operate than with the broader question of what the standard should be.

Comprehensibility of the standards and penalties is also important to IRS in its administration of the penalties. As penalties become more numerous and more complicated, it becomes more difficult for an employee of the IRS to be aware of all penalties and to make quality judgments as to when they should be asserted or abated. Thus, complexity works against both a taxpayer's ability to understand the consequences of noncompliance and the Service's ability to administer the system effectively and fairly.

D. ADMINISTRABILITY. Penalties should be designed to maximize fairness, effectiveness, and comprehensibility in their practical application rather than in theory. Administrability in this sense requires that each penalty be designed to maximize the certainty that it will be imposed when it should be and not imposed when it shouldn't be. Thus, administrability is a key ingredient for deterrence and just deserts, Likewise, for a standard of behavior to be validated, penalties need to be imposed appropriately. The legitimacy of the procedures used in uncovering and penalizing inappropriate behavior is closely related to the perceived legitimacy of the system, and can have a profound impact on the willingness of taxpayers to comply voluntarily. Designing a penalty for administrability must deal with three major issues:

1. ROLE OF ADMINISTRATIVE DISCRETION. A penalty should be keyed to the development of a clear and appropriate standard of behavior with a set of criteria that should be taken into account in determining whether and to what extent that standard has been violated. The role of the administrator is, then, to exercise administrative discretion in applying those criteria to instances of possible breach of the standard with the objective of correctly and consistently categorizing the possibly noncompliant conduct.

The goal of certainty of application turns on properly categorizing taxpayers with respect to whether they have violated a standard of behavior. Just as penalties should be designed to encourage voluntary compliance, so they should be administered for this purpose. Thus, the administrator and the designer have a common goal and must allocate responsibilities between themselves. The design of a penalty necessarily sets limits on the discretion of the administrator. The discretionary decisions made by the administrator necessarily determine how well and to what extent the design is implemented. Thus the optimum allocation of responsibilities between designer and administrator is in the interest of all.

Written rules should guide the administrator to the correct result, and clearly this requires that the rules have a certain level of detail. Broad administrative discretion can be troubling if regulations and statutes do not adequately guide it. The last two decades have seen a tendency toward greater reliance on such written rules in many areas of administrative law, and the tax law is no exception. Statutes and interpretative regulations tell the administrator what general goals or policies are sought by society. In the absence of such direction, an essential public, political perspective is lost. However, the complexity and diversity of everyday life also require that the administrator have substantial powers and resources. These are needed simply to develop facts and sort cases into appropriate categories. If the goal of a penalty were simply to impose a sanction when particular facts existed, perhaps this authority would suffice. But pursuit of more abstract goals (voluntary compliance, for example) leads to significance for more ambiguous facts (for example, whether the taxpayer was negligent), and to the impossibility of developing a statutory or regulatory scheme that covers all combinations of relevant facts (thus waivers for reasonable cause are permitted). These complexities and ambiguities prevent the success of statutory or regulatory attempts to provide more detailed, specific guidance. Such attempts lead to results that conflict with underlying policy goals. Excessively detailed guidance either prevents administrators from giving appropriate weight to unusual facts or becomes so complex that it exceeds the practical abilities of the administrator to understand and apply it. Either the administrator becomes a parser of complex rules, substituting the result required by the rule for the judgment that the case may require; or he bends the written rule to reach the result that he feels is reasonable. The unreasonable or inconsistent result may beget more regulations, procedures, and manuals intended to correct such problems. However a better response might be simpler rules that better allocate responsibilities between the rule writers and the administrators.

The Task Force is of the view that the job of design is to determine what standard of behavior should be expected of taxpayers and what sanctions should exist for contravention of that standard. The job of administration is to determine when such a standard has been breached and whether the breach should be excused. The designer of a penalty can be of help to the administrator in making such determinations by setting forth factors that the administrator should take into account, but the designer should resist the temptation to establish hard and fast rules requiring the assertion of a penalty in particular circumstances. The designer is poorly positioned to determine either whether a specific situation runs afoul of the standard, or whether, given competing administrative needs, a particular factual situation should be pursued.

In any particular area, the allocation of responsibility between design and administration is a matter of judgment. However, the general concept can be illustrated by looking at two negligence penalties. The basic negligence penalty of section 6653(a) properly allocates the responsibilities of design and administration. The designer has established the standard of behavior and the amount of the sanction; the administrator has the discretion to make case-level determinations based on that standard. On the other hand, the negligence penalty of section 6653(g) requires IRS to penalize each individual who fails to report all income on information returns unless a very stringent standard of proof is met. In this penalty, case-level decisions properly the province of the administrator have been taken over and answered in the design of the penalty itself. Not surprisingly, IRS is having difficulty administering this penalty in a satisfactory way.

2. NEUTRALIZATION OF SEVERE SANCTIONS. Administrability is affected by the amount of the penalty. While increasing the severity of a penalty will, up to a point, arguably achieve an increased deterrent effect, such sociological evidence as exists suggests that, when the severity of the penalty exceeds that which is perceived as fair, such severe sanctions are very difficult to impose. Taxpayers, perceiving the penalty as unfair, tend to contest it, leading to more appeals, complaints, adverse publicity and bad relations between IRS and practitioners. Therefore, these sanctions tend to be neutralized by nonimposition. Thus the administrability of a penalty may be decreased by penalties that are excessively severe.

3. DEALING WITH LIMITED RESOURCES. The Mission of IRS has implicit within it two goals that must be balanced: encouraging the highest degree of public confidence in the agency and collecting the proper amount of tax at the least cost to the public. The IRS's pursuit of efficiency and the reality that the law must be administered with limited resources has implications for the design of penalties. Increasing fairness by making fine gradations of proportionality or adding specific penalties for specific failures to comply, defining standards of behavior based on more fair subjective criteria rather than objective criteria, using penalties as a way to educate taxpayers, maximizing effectiveness by considering assertion of penalties in cases of marginal noncompliance, and encouraging a proactive investigation of possible cases for waiver or abatement of penalties all require that resources be devoted to the administration of penalties and not to other areas that compete with penalties.

Accordingly, an administrable penalty system must achieve certainty within the limits of available resources and administrative capabilities. This necessarily leads to consideration of actions such as the use of computer-aided technology to assure certainty without the high costs associated with hand-checking for potential errors, the use of administrative tolerances or other discretionary devices to avoid pursuing marginal cases, the use of informal abatement procedures to waive penalties based on representations of the taxpayer rather than investigation of the facts represented, the settlement of arguably valid IRS positions to avoid the cost of litigation, and other actions all of which reflect the fact that unlimited resources do not exist. Just as the IRS must target enforcement efforts to maximize its compliance impact based on limited resources, so the design of penalties should follow a course that recognizes the limited resources for administration of penalties. Specifically targeted penalties aimed at marginal noncompliance, elegantly structured but difficult-to-administer penalties, and legislative or regulatory demands for scarce resources in particular areas that prevent the broader consideration of competing resource needs should be avoided.

IV. COMPROMISES AMONG THE FACTORS

The criteria suggested above are not always consistent with one another. Any system of penalties requires tradeoffs. A system that is perceived as fair by penalized taxpayers may be too lenient and, therefore, ineffective. The system that, on average, is fairest from a theoretical perspective may be too complicated. A system that is easily administered may not be fair or simple.

Making good decisions about tradeoffs is the key to a good penalty system. But developing sufficient information and making good decisions can be difficult. The complexity itself is daunting, for the way in which the factors should be evaluated may vary from penalty to penalty. For example, increased perceptions of fairness that can be achieved only through a more complicated structure may be desirable in the case of penalties imposed on large institutional taxpayers but not in the case of those imposed on taxpayers filing simple individual returns.

With some penalties, the standard of behavior that is protected may require more flexible administration than with others. For example, the standard protected by the failure to file penalties seems straightforward compared to the standard protected by the substantial understatement penalty; thus more administrative flexibility may be required in the latter case. Effectiveness in the case of a penalty designed primarily for its general deterrent effect and imposed upon taxpayer actions that ordinarily are not expected to be voluntarily corrected (e.g., the fraud penalty) may be a simple matter of establishing the correct amount of the penalty and having an effective detection program. Thus simplicity and administrability can be emphasized. However, effectiveness may be a relatively more important and difficult goal for penalties that have a more important specific deterrence objective or, like the payor penalties in the information reporting area, should be designed to encourage the voluntary correction of noncompliance.

How can we develop a way of weighing and reconciling the various factors discussed above? In part, these tradeoffs depend on the particular purpose for which a penalty is designed. For example, evaluation of a penalty that is designed primarily for a specific deterrence purpose, where the norm to be supported is well understood and accepted and the mechanics of computation are straightforward, might focus on fairness and effectiveness. On the other hand, evaluation of a penalty that is directed primarily at defining and supporting a norm that is difficult to articulate and is subject to disagreement might concentrate primarily on fairness and administrability. The specific role of the penalty and the specific problems that arise in evaluating it will have much to do with the identification of the evaluative criteria that are most important to pursue in the event of conflict.

One problem that inevitably will require trade-offs is the problem of false positives and false negatives. In any statutory scheme, the complexity of everyday life requires simplification. The statute must give general rules for application, and these general rules are applied. Cases that do not fit the general rule are likely to be treated incorrectly. This means that some taxpayers who should be penalized will not be (a false negative) and that some taxpayers who should not be penalized will be (a false positive). Should the penalty system deal expressly with these problems? Should the system be "tilted" toward one or the other? While any tilt should be minimized to the extent possible, the Task Force believes that, at the fringes, penalizing those who should not be penalized creates more negative attitudes and more problems than providing a slight tilt toward allowing some taxpayers who have violated a standard of behavior to avoid penalties. The focus group study that the Task Force commissioned tends to confirm that taxpayer attitudes are more negatively affected by improper penalization of taxpayers than by the exhibition of some leniency. The facts of administration of the tax system require a certain amount of leniency in any case, and thus such a tilt is consistent with the everyday realities of IRS.

These observations have implications not only for the design of a statutory framework, but for the procedures and data collection system in place to administer the penalty. Thus, to determine whether a penalty is well designed may require ongoing research efforts. Certain types of noncompliance (especially those that are easily identified on an ongoing basis by IRS) might best be regulated through a tracking system that minimally penalizes the initial incident of noncompliance but then subjects ongoing noncompliance to progressively stiffer penalties that increase the cost of continued failures. However, such an approach is likely to require an assessment of IRS capability to capture and call up such recidivism. In other words, what is likely to prove most effective may be difficult to administer in a consistent way, with collateral implications for the goal of fairness.

In summary, the analysis of these factors as they relate to particular penalties and compliance areas must be approached on an issue-by-issue, penalty-by-penalty basis and temptations to simplify or paint with a broad brush should be carefully considered, if not avoided entirely.

CHAPTER 4

A PHILOSOPHY OF PENALTY ADMINISTRATION

I. INTRODUCTION.

Chapters 2 and 3 address the design of penalties. Design occurs in the legislative and regulation-writing processes. The best design possible is still only a blueprint for IRS. IRS implements the blueprint by deciding whether and how to assert penalties and when to abate or waive them, but it must weigh legislative intent, available resources, compliance impact, and other factors in doing so. This chapter considers the policies that IRS should pursue in making these decisions. These policies grow naturally out of efforts to achieve the goal of penalties set forth in Chapter 2.

Encouraging voluntary compliance assumes that taxpayers understand their obligations. Accordingly, one key strategy is educating taxpayers about their obligations. To deal effectively with how, when, and why penalties should be asserted requires the establishment of standards for development and implementation of penalty programs. Both education and penalty programs require a skilled work force. Thus, training of IRS personnel is important. Finally, sound management requires management information systems and research programs to evaluate programs and training and the use of such evaluations to improve management.

II. TAXPAYER EDUCATION.

Based on its Mission, IRS has the obligation to establish conditions that permit the taxpayer to comply with the law. Penalizing taxpayers for failures to comply with their tax obligations assumes that they have or should be charged with an understanding of these obligations and that they have everything that they need to be able to comply. To give the taxpayer this understanding and these aids to compliance, IRS develops, publishes, and distributes forms, instructions, and publications; issues regulations, revenue rulings, and revenue procedures; and operates outreach and assistance programs.

The IRS has the obligation to make taxpaying as clear and easy as possible, but the importance of providing taxpayers the means to comply with the law should not be confused with the responsibility for actual compliance. Taxpayers must make the effort to understand their obligations and comply with them. IRS is not, and should not be, required to inquire into the actual knowledge of taxpayers prior to asserting a penalty. Often noncompliance caused by a lack of understanding of one's obligations is due to a lack of attention to or diligence in determining one's obligations. In this situation, a penalty may be an appropriate means of prodding the taxpayer to exercise due diligence in seeking to comply with his obligations. In this context, IRS should seek to use the occasion of a penalty assertion as an opportunity to educate the taxpayer as to his obligations.

In summary, a fundamental goal of tax administration is to provide to taxpayers the understanding and the means to comply with the law. The occasion of asserting a penalty should be used in appropriate cases to identify the existence of broad compliance problems and educate the taxpayer as to the obligations with which he has failed to comply.

III. DEVELOPMENT OF PENALTY PROGRAMS.

Principles of fairness require that penalties be asserted based on approaches that treat similarly situated taxpayers similarly and that give the noncompliant taxpayer his just deserts. Effectiveness in deterring noncompliance requires that noncompliant taxpayers, once identified, have appropriate penalties asserted against them. Neither of these objectives can be achieved through the assertion of penalties in an ad hoc manner. Only through the development of programs for the assertion of penalties can certainty and consistency be assured.

Recent studies suggest that the procedural handling of a case may be as important as correctly resolving it. Standards of behavior are validated by perceptions that a fair and impartial procedure exists to resolve a penalty case. The moral force of deterrence is enhanced by perceptions that a penalty is fairly and consistently applied and the economic deterrence inherent in penalty is served by expeditious and consistent treatment. The very concept of just deserts is that the noncompliant taxpayer be perceived as having been justly treated, and this necessarily encompasses perceptions as to the fairness of the procedures followed in resolving contested cases as well as the correctness of the initial or final assertion. A fair and consistent procedural approach to cases is most likely to result in fair and consistent substantive decisions. Additionally, due process -- administrative as well as judicial -- is an important normative value in our democratic system of government.

Based on the foregoing considerations, the Task Force developed the following goals for the development and administration of programs to assert and resolve penalties.

A. CONSISTENCY.

The use of penalties to deter misconduct, to deliver just deserts, and to validate behavioral standards requires that taxpayers expect the penalty to be imposed and that the penalty be imposed in fact in a consistent way. Consistency of application is implicit in the design goals of fairness (especially equity), effectiveness, and administrability. Consistency has many facets, including consistency between similarly situated taxpayers; consistency of application from year to year; consistency with the prior experience of an individual taxpayer; and consistency with the recent experiences of family, friends, and acquaintances.

A necessary part of any program for penalty assertion is the exercise of administrative discretion not to pursue cases that arguably merit a penalty. Resource limitations, the perception that pecadilloes should not be punished, and giving the taxpayer the benefit of the doubt all result in choices not to pursue some meritorious cases. The question thus arises, what principles should be followed in the design of penalty programs so that the positive effects of such choices are maximized and the negative effects are minimized. An ongoing objective should be to develop a better understanding of how programs for the assertion of penalties can be most effectively designed and executed. While the Task Force has not undertaken this effort, some basic criteria are suggested:

1. The effects of incorrectly penalizing compliant behavior are negative, even if they are later corrected, and therefore should be minimized. A penalty asserted in error confuses taxpayers as to the behavior desired. It also leads taxpayers to question the fairness of the tax system and the ability or desire of IRS to administer it. As the focus group report suggests, a penalty asserted in error, even if subsequently waived, creates negative attitudes toward the tax system and the IRS, perhaps negatively affecting voluntary compliance. Thus, in the development of penalty programs, assertions that will eventually result in penalty waivers should be minimized.

2. Penalty programs should consistently identify and assert penalties against these taxpayers who are the most culpable either because of the extent of a particular violation or the consistent pattern of violations over time. Those who deviate farthest from a standard of behavior should be the ones who receive the greatest penalty (as well as having the greatest likelihood of getting caught). This may have implications for the design of penalties -- leading to a preference for graduated penalties -- and may have implications for the types of taxpayer information that should be available to IRS. Tracking culpability over time will require more historical information.

3. Taking the two above principles together suggests that in the case of the marginally noncompliant taxpayer, the person who is making a reasonable effort to comply for the particular situation and expected level of skills, the benefits to voluntary compliance of penalizing him must be weighed against the possible cost of an erroneous assertion, and one may reasonably conclude in a given situation that the costs outweigh the benefits.

4. Effective, correct, and efficient instructions, procedures, and training to handle abatements of penalties should accompany the establishment of any penalty program.

B. REPRESENTATION.

The taxpayer should have an opportunity to effectively communicate with IRS about the specific details of the taxpayer's case and the communications should be with one who has discretion to abate the penalty if abatement is warranted. If a taxpayer is, or believes he has been, incorrectly penalized, he generally has a need to communicate with IRS personnel either to understand the reason for the penalty in the particular case, to raise new facts, to contest the penalty's assertion, or to understand how to avoid future penalties. Inability to reach IRS, the failure by IRS to give the taxpayer the advice or guidance needed, or simply the expenditure by the taxpayer of excessive effort to resolve a case may cause a decline in confidence in, or respect for, IRS and the tax system.

Giving the taxpayer a voice in the resolution of his case does not, of course require that the taxpayer control the resolution of his case. But it does go beyond providing a mere pro forma opportunity to request an abatement. Implicit in the concept of providing the taxpayer an opportunity for representation is the proposition that this opportunity be to raise points or arguments with one who has the power to resolve the case. Thus, for example, if the taxpayer has a meritorious ground for abatement but must raise it with an examiner who has no discretion to accept this particular ground, the goal of representation has not been met. That the taxpayer may, after denial, appeal and have the case reheard by one who does have authority to abate is not a complete answer because the additional effort required in second and successive appeals itself constitutes a barrier to effective representation.

Internal procedural complexities should not make a case more difficult for the taxpayer to resolve. Since the correct substantive disposition of a case is essential, IRS personnel should have a proactive approach to case resolution and should, to the maximum extent possible, remove barriers to such a resolution. Such barriers could include the excessive expenditure of time and effort on the part of the taxpayer or the need for specialized knowledge or expertise such as that provided by taxpayer representatives.

C. DECISION ACCURACY.

Setting and validating standards of behavior, deterring noncompliance, and giving the noncompliant their just deserts require that IRS seek to resolve each case involving potential penalties correctly. Incorrect application of a penalty confuses the question of what conduct is compliant, angers taxpayers who are unjustly penalized, and causes others to question the fairness of the system. Implicit in concerns about consistency and representation is a concern that the agency make good substantive decisions. Consistency alone will not assure good decision accuracy, nor will providing the taxpayer with an opportunity for representation. Concern with decision accuracy must be a separate and equally important goal. This requires that the agency commit itself to obtaining the information needed to make good decisions and that it develop both the capability and objective of using this information to arrive at a correct resolution of the case.

Correct assertion of a penalty rests on the administrator's balancing of many competing factors. Available facts should indicate that the statutory and regulatory criteria for assertion exist. Otherwise, the penalty should not be asserted. Beyond the fact that a case apparently or arguably meets the criteria for asserting a penalty is whether a discretionary decision not to assert the penalty should be made. Such a decision might reasonably be made for any of a number of reasons, including resource limitations, extenuating circumstances, or lack of needed guidance. Each of these situations involves a judgment call as to whether the taxpayer's conduct is reasonable or acceptable under the circumstances, and some of them deal with whether noncompliant conduct should be excused.

Some decisions about administrative procedures reduce incorrect assertions but at the cost of not penalizing some who should be penalized. What procedures should be adopted for a particular standard of behavior depends on both the effect of such procedures on incorrect initial assertions and the extent to which such procedures create loopholes for the guilty. Given the damage caused by allowing the guilty to go unpunished, enforcement systems must often accept a certain number of false penalties in the initial round, and then devise a way to correct these mistakes.

D. CORRECTIBILITY.

As the quality of initial decisions encourages voluntary compliance, so the quality of final decisions serves the same purpose. Thus the administration of penalties requires an opportunity to correct mistakes. Since the system of asserting penalties can initially take into account only facts in IRS's possession, mistakes will be made. Facts subsequently raised will sometimes establish the need to reverse an initial assertion. Additionally, as in any large organizations, human errors will be made. If such an error is made or later evidence shows that a penalty was incorrectly asserted, it should be abated. Perceptions of fairness turn in part on the commitment by the administrator to review and correct mistakes. In the context of penalties, this encompasses the need for an effective and accessible review and appeals apparatuses that correct errors as the agency discovers them and that provide taxpayers a way to get errors corrected.

The development and implementation of penalty assertion programs should anticipate the need for abatements and dispute resolution and establish guidelines for these matters. Further, in establishing a program, the resource needs for handling such problems should be projected and provided.

E. BIAS SUPPRESSION.

A major factor in encouraging voluntary compliance is the perception that taxpayers will be fairly treated by IRS. This in turn requires a view that in seeking the correct resolution of cases the agency does not act in a biased way. Lack of bias requires that IRS employees be honest. It also encompasses the need for impartiality. Impartiality requires that the administrator in enforcing the law neither blindly and without question take the government's position nor unquestioningly accept the taxpayer's assertions. In accordance with IRS's mission statement, the objective of the agency is to collect the CORRECT tax, neither the maximum tax nor the amount that the taxpayer is willing to pay. While each IRS employee appropriately approaches his or her job from a government perspective and with the objective of protecting the government's interest, the true interest of the government is the impartial enforcement of the tax laws, and this requires that treatment of taxpayers not be biased. One measure of whether such bias suppression is in fact achieved may be the effort that the agency expends in its efforts to be fair in achieving some of the other goals set forth above. Another area for exploration is the need for (or adequacy of) policy guidelines in approaching factual claims in a way that gives appropriate weight to reasonable taxpayer claims even when not completely documented.

F. TAXPAYER RIGHTS.

Generally the taxpayer in a penalty case is engaged in a dispute involuntarily. Many taxpayers do not have a sophisticated understanding of tax procedure. In this context, it becomes important to the fairness of the dispute resolution process that taxpayers be advised of their rights and assisted in pursuing avenues of representation or appeals and that the employee assisting them make them familiar with and observe their procedural rights.

G. EFFICIENCY.

Prompt processing of taxpayer cases is a value in and of itself. To some extent the procedural values set forth above can be achieved perfectly only by rather elaborate and time-consuming (both for the IRS and for the taxpayer) procedures. For most individual taxpayers, formal procedures get in the way of practical procedural justice by increasing the cost of any controversy. The ultimate procedural protection for taxpayers is the federal court system, with its elaborate constitutional and other procedures and safeguards. Given this backstop and the fact that the IRS must be operated with limited resources, some informality in the administrative procedures is highly desirable. Of course, such informal procedures must also take into account the need for consistency. To a very large extent, the procedural values suggested above must be implemented through the informal conduct of the IRS workforce and the development of management and training techniques that preserve consistency in such an informal environment.

The goals suggested above cannot be simultaneously realized. Perfect consistency as a practical matter conflicts with goals for representation and correctibility, which give the taxpayer some control over the consideration and resolution of a case, thus encouraging some inconsistencies. Goals for representation require the IRS to represent the government's position in a dispute and thus is to some extent at odds with bias suppression. Decision accuracy requiring that the agency gather sufficient information to make a correct decision initially may conflict with efficiency concerns that might best be served by asking the taxpayer to develop facts after initial assertion of a penalty. These competing goals must to some extent be resolved not at the individual case level, but rather in the broad, program-planning for assertion and resolution of penalty cases.

IV. TRAINING OF IRS PERSONNEL.

An assumption of any penalty program, and any educational efforts undertaken by IRS is that IRS personnel are prepared to handle such programs. This requires that personnel be trained. In particular, intelligent administration of penalty programs requires a workforce that understands the goals and purposes of penalty assertion and the underlying reasons for waiver or abatement. Since all penalties ultimately play out in the context of individual taxpayer cases and a goal of the programs is to resolve disagreements without imposing a great deal of inconvenience or effort on the taxpayer, personnel dealing with such cases must receive the training to be able to use their judgment in making correct dispositions of those cases rather than merely applying a rote set of criteria and passing problem cases up to a higher level of review. Accordingly, training personnel who deal with penalties on the underlying goals and objectives of assertion as well as on the technical rules governing a penalty is required. Training should be looked upon as a constant activity in which examiners have the chance to discuss difficult cases within the work unit and the appropriate way to handle discretion on them.

V. MANAGEMENT INFORMATION SYSTEMS AND RESEARCH PROGRAMS.

If penalties are to be used to achieve an improvement in compliance and an objective of the IRS is to correctly resolve disputed cases without undue effort and delay on the part of taxpayers, systems must be established to collect information that will permit an assessment of the job done. Additionally, if an objective of penalty programs is to be most certain of penalizing the most culpable, identifying the most culpable noncompliers requires information systems that can track relevant data. Finally, whether the statutory terms of each penalty can potentially have the desired impact on noncompliance requires research programs to gauge the results of assertion. Thus, any penalty program should include a management information system to capture relevant data and research projects to assess whether the program is achieving the desired effect.

VI. EVALUATION AND IMPROVEMENT OF THE PENALTY SYSTEM.

When a program is not working well, or a penalty does not have the desired effect or creates undue negative feelings among taxpayers, or the IRS is not administering a penalty as well as is desired, the IRS should recognize that it has the responsibility to make recommendations for, and to the extent feasible implement, changes to fix the problem. Ongoing responsiblity and efforts in this area are required.

VII. CONCLUSION.

Adherence to the foregoing goals in the development and administration of compliance programs relevant to penalties should help in developing an administrative approach that encourages compliance before any penalizable conduct occurs by educating the taxpayer; administering the penalties when they are needed in a consistent and fair way; and continually gathering and evaluating data regarding the penalties so that necessary change can occur on an ongoing basis.

CHAPTER 8

ACCURACY OF INFORMATION

I. INTRODUCTION.

This chapter discusses the penalties associated with the taxpayer's duty to file an accurate return. The primary penalties relating to this duty are the negligence, fraud, and substantial understatement penalties, but many other specialized penalties such as the valuation and preparer penalties deal with particular types of errors or ancillary issues.

II. THE NEED FOR A CODIFIED STANDARD OF BEHAVIOR.

A. THE STANDARD OF BEHAVIOR IN 1954.

From the inception of the modern federal income tax, penalties with respect to negligent and fraudulent understatements have existed. In 1954, a 5 percent negligence penalty applied if an understatement was attributable to a careless, reckless, or intentional failure of the taxpayer to comply with the rules and regulations, ¹ while a 50 percent fraud penalty applied if an understatement was due to a knowingly false material representation by the taxpayer. ² These penalties established that the taxpayer had to file a nonfraudulent and nonnegligent return.

This expectation of nonfraudulent and nonnegligent conduct had its analogy in professional standards. Perhaps the best expression of this analogy is in Formal Opinion 314, issued by the American Bar Association's ("ABA's") Committee on Ethics and Professional Responsibility in 1965. In this document, the organized bar presented its view as follows:

A lawyer who is asked to advise his client in the course of the preparation of the client's tax returns may freely urge the statement of positions most favorable to the client just as long as there is reasonable basis for those positions. Thus where the lawyer believes there is a reasonable basis for a position that a particular transaction does not result in taxable income, or that certain expenditures are properly deductible as expenses, the lawyer has no duty to advise that riders be attached to the client's tax return explaining the circumstances surrounding the transaction or the expenditures. ³

The AICPA adopted a similar position in Statement on Responsibilities in Tax Practice No. 10: "In preparing a tax return a CPA may take a position contrary to Treasury Department or Internal Revenue Service interpretations of the Code without disclosure, if there is reasonable support for the position." Further, the Treasury Department itself adopted a standard for those enrolled to practice before it that was based on the concept of "due diligence," a standard closely related to the professional ethical standards expressed above. ⁴

In the late 1950's and 1960's, the "nonnegligent" standard for taxpayers inherent in section 6653 of the 1954 Code, the ABA's "reasonable basis" standard, the AICPA's "reasonable support" standard, and the "due diligence" standard of Circular 230 all pointed to a single understanding of both the taxpayer's and the practitioner's duty in preparing or filing a return. This standard could be called the "litigating" standard, since it is based, quite clearly in Opinion 314, on the proposition that IRS is the taxpayer's adversary and that, accordingly, IRS should be treated like one's adversary in a civil proceeding. This point of view may come from the fact that before paying a contested income tax, the taxpayer can generally litigate the liability in the U.S. Tax Court. ⁵ This consensus regarding the appropriate standard masked, as the subsequent discussion will show, a great deal of underlying ambiquity as to the meaning of the standard and how it should be applied.

The historical materials available suggest that the primary considerations associated with adoption of the "reasonable basis" standard revolve around the identification of a taxpayer's legal rights as expressed in the Code at the time and the professional responsibility of lawyers and accountants to represent their clients zealously within the bounds of the law. The broader interests of society in assuring accurate and voluntary self-assessments of tax liability do not seem to have been raised and discussed in arriving at this standard of conduct. These concerns with accurate and voluntary self-assessment came to the fore in the 1970's and 1980's with a variety of events.

As a result of the focus on the abuses of the "reasonable basis" standard in the tax shelter area, the organized bar began work on a clarification (or modification, depending on one's point of view) of this standard. This work culminated in Formal Opinion 85-352, which substituted in essence a "realistic possibility of success if the matter is litigated" ⁶ for the old reasonable basis standard.

B. COMPLEXITY AND THE REASONABLE BASIS STANDARD.

In the 1970's, tax shelters became a primary focus of tax planning and of controversy. The tax shelter problem seems initially to have been seen as the result of substantive shortcomings of the Internal Revenue Code. For example, the Tax Reform Act of 1976 made a variety of technical changes, including most notably the addition of the at risk rules of section 465, to prevent what was, even then, labeled as "this abuse in tax shelters." ⁷ While this substantive view of tax shelter problems has continued through a series of highly technical and complex enactments, other interpretations of the tax shelter problem were not long in coming. ⁸

C. EROSION OF THE REASONABLE BASIS STANDARD.

1. DISCLOSURE REQUIREMENTS. In 1977 and 1978, the then- Commissioner of Internal Revenue, Jerome Kurtz, linked two other aspects of the problem of questionable positions -- the audit lottery and the standard of reporting. Kurtz pointed out that the absence of any required disclosure of aggressive positions effectively resolved uncertain issues in the taxpayer's favor because the complexity of the law and many taxpayers' affairs and the low percentage of returns audited by IRS made discovery unlikely. ⁹

Mr. Kurtz's theme of disclosure found its culmination in the 1982 enactment of section 6661. This provision imposed a 10 percent penalty on certain understatements attributable to an undisclosed position that was not based on substantial authority. One can interpret the provision either as a substitution of a higher, objective standard for the "reasonable basis" standard (a view implicit in the widely criticized 1986 proposal for change to Circular 230) or as an economic toll charge for the opportunity (still completely legal and ethical) to take an undisclosed "reasonable basis" position without substantial authority. Whatever one's viewpoint, the provision clearly arose out of a dissatisfaction with the pre-enactment status quo.

2. TAX SHELTER OPINIONS. A second major object of discussion was that of the tax lawyer's role in the development and sale of tax shelter investments. Here, the existence of clearly abusive opinions led to the identification of concerns that also seemed present when the attorney gave an opinion within the bounds of the reasonable basis standard. Both government officials and the organized bar suggested that "reasonable basis" opinions were inappropriate:

Is the lawyer's role in advising a single client with respect to a transaction already consummated to be governed by the same standards as the lawyer's role in helping set up and promote a tax shelter to be offered to numerous investors? A substantial number of thoughtful tax practitioners take the view that it is unprofessional conduct for an attorney to give a "reasonable basis" opinion that he knows will be used to lead many people to assert tax positions that he believes are not sustainable. In its recently published Guidelines for Tax Practice, the Committee on Standards of Tax Practice of the ABA Section of Taxation warned that in the circumstances of promoting a tax shelter, the giving of an opinion "may be taken by the public as our endorsement of the program." Accordingly, the Guidelines take the view that tax attorneys should not assist in the offering of tax shelters which are without economic substance and without a substantial likelihood of legal validity. ¹⁰

Mr. Mundheim's views as to the role of the "reasonable basis" opinion in the marketing of tax shelters found its culmination in the adoption of revisions to Circular 230 by the Treasury Department and the promulgation by the American Bar Association of Formal Opinion 346. These documents required one giving an opinion in connection with an offering to make appropriate inquiry into the facts surrounding the investment and to provide, to the extent possible, an overall evaluation of the likelihood that the contemplated tax benefits would be realized. In addition, both documents required the advisor to reach a conclusion with respect to each material issue as to the probable outcome. In Circular 230, this is expressed by requiring the practitioner to "provide an opinion whether it is more likely than not that an investor will prevail on the merits of each material tax issue presented by the offering which involves a reasonable possibility of a challenge by the Internal Revenue Service." ¹¹

3. HARSHER PENALTIES. While changes in the substantive law, in the disclosure rules, and in the tax shelter opinion area can all be seen as intellectual responses to shortcomings of the "reasonable basis" standard, a more simple response was also brewing. This derived from the viewpoint that compliance problems in the shelter area were not attributable to a poor reporting standard or to lack of disclosure, but rather were caused either by the absence of sanctions or by sanctions that were not tough enough. Thus, in 1976 a decade of amendments that toughened the reporting penalties started.

In the Tax Reform Act of 1976 Congress responded to IRS studies showing abuses by some income tax return preparers by requiring preparers to sign returns and providing that preparers could be penalized for failure to observe the reasonable basis standard. ¹² This enactment did not suggest change to the reasonable basis standard, but did indicate concern that returns filed did not reflect the level of accuracy or care that was desirable and that existing sanctions in the Code provided an insufficient support for such standard.

Additional changes to the understatement penalties shortly followed. In the Economic Recovery Tax Act of 1981 ("ERTA"), the negligence penalty was increased by adding a supplemental penalty of 50 percent of the interest attributable to the portion of a deficiency out of which the penalty arose. ¹³ ERTA also provided a negligence penalty that presumptively applied to certain unreported straddles and a penalty that applied to individuals and certain corporations that made a valuation overstatement. ¹⁴ Reasoning for the addition of the penalty on valuation overstatements was the presence of about 500,000 tax disputes involving valuation questions "of more than routine significance."

The Tax Equity and Fiscal Responsibility Act of 1982 ("TEFRA") followed the toughening of understatement penalties in ERTA with a further stiffening of the penalty provisions. An interest surcharge similar to that previously adopted for the negligence penalty was adopted in the fraud area. ¹⁵ The substantial understatement penalty previously mentioned was enacted. Additionally, the failure to report interest and dividend income became subject to a presumptive negligence penalty.

Variations on this deterrence theme were played once more in the Tax Reform Act of 1984, when the interest rate for tax motivated transactions was raised to 120 percent of the otherwise applicable rate and the valuation penalty was broadened through the addition of section 6660 to the Code. The 1986 act continued the trend with the increase of the fraud penalty to 75 percent, the further broadening of the valuation penalties to pension matters with the addition of section 6659A to the Code, and the extension of the negligence penalty to all taxes. This act also changed the definition of negligence to include "any failure to make a reasonable attempt to comply with the provisions of the Code." Finally, it increased the amount of the substantial understatement penalty to 20 percent, a level immediately raised to 25 percent by the Omnibus Budget Reconciliation Act of 1986.

D. CONCLUSION.

In summary, the proposition that taxpayers are entitled to take any undisclosed position on their tax return so long as that position is supported by a reasonable basis has a checkered history at best. It has played a starring role in the extremely complex technical response to tax shelters, has led to new disclosure requirements, has been discredited in the area of tax shelter opinions, and has been a major impetus for ten years of increasingly harsh penalty legislation. Much of this legislation suggests that dissatisfaction with the reasonable basis standard is such that it is a fundamental impediment to better tax administration. Circumventing the negligence-based standard by adding toll-charges such as 6661, adding penalties objectively punishing departures from accuracy (such as 6659), and utilizing evidentiary presumptions to shift the burden of proof from IRS to the taxpayer (e.g., section 6653(g)) all have blurred the question of what standard of behavior should exist in the area of accuracy and have raised serious questions about the fundamental fairness of the sanctions provided by the Code.

The Task Force believes, in accordance with the philosophy of penalties which it has adopted, that a standard of behavior with respect to accuracy should be expressly set forth in the Internal Revenue Code and that, to the extent that the existing penalties fail to conform to that standard, they should be carefully studied to determine whether they should be brought into conformity or repealed. Any standard of behavior adopted should be properly coordinated with the traditional role of attorneys, accountants, and others whose obligation is to advise their clients under the law.

III. STANDARD OF BEHAVIOR FOR ACCURACY.

A. IN GENERAL.

1. WHO SHOULD SET A STANDARD OF BEHAVIOR. What standard of behavior taxpayers should observe is a question in which not only IRS, but also taxpayers, practitioners, and legislators have important stakes. The issue was originally addressed to some extent through passage of the negligence penalty and has implicitly been the subject of much subsequent legislation. Accordingly, it is the Task Force's view that such a standard should be resolved through the political process and that unilateral adoption of a standard by IRS would be inappropriate. IRS's role as the administrator of the tax system, however, means that it does have an important perspective on what approach is most likely to result in the best balance between effective administration, taxpayers' rights, and simplicity. Accordingly, the following views are provided.

2. POLICIES TO BE RECONCILED. As with penalty provisions themselves, an overriding goal in developing a standard is that it positively impact voluntary compliance. In the abstract, voluntary self-assessment of the correct tax liability would be encouraged by a standard that demanded a high level of care (e.g., best efforts) and a high level of certainty (e.g., that no reasonable grounds exist for a contrary position). However, such a standard would be unobtainable in the real world and fails to take account of a number of competing or complementary policies that must be considered.

In addition to encouraging voluntary compliance, a standard of behavior for taxpayer conduct should adequately take into account the following:

o First, consideration must be given to the taxpayer's right to litigate bona fide issues before payment of any tax liability attributable thereto.

o Secondly, the standard should be such that it is within the capability of every taxpayer to achieve compliance.

o Thirdly, the standard should be understandable and understood by taxpayers who prepare their own returns and are not represented by professionals.

o Fourthly, the standard should be consistent with the standard by which the conduct of professionals is judged.

B. DEFINING THE STANDARD.

In the view of the Task Force, a standard of behavior for accuracy must address three key issues: the level of care expected of taxpayers, the level of accuracy to which they must aspire, and the role of disclosure.

1. LEVEL OF CARE. In the debates regarding accuracy, the level of care expected of taxpayers has received little attention, while the question of accuracy has been much examined. This perhaps reflects the fact that little disagreement exists, or perhaps the fact that the accuracy issues have been so acute that concerns about level of care have been ignored. For the most part, the existing level of care is based on a negligence concept. In section 6653(a), this is explicit. The due diligence standard in section 6694 seems also to expect the practitioner to utilize due care, or reasonable care under the circumstances to prepare the return. Such a standard has much to recommend it, since it can be flexibly applied under varying factual circumstances and is also implicitly the standard for professional advice, violation of which can give rise to a malpractice claim.

An alternative approach is provided in section 6661, which establishes an objective standard not related to the care with which the taxpayer accomplishes his task. This objective standard makes for simpler administrative action but has a variety of shortcomings. First, not being based on a failure by the taxpayer to do what is reasonable under the circumstances, it punishes behavior in situations in which reasonable care was perhaps exercised. Secondly, not being based on conduct that is negligent or otherwise subjectively culpable, it lacks moral or ethical force and thus must rely for its efficacy exclusively upon the size of the economic sanction imposed and the likelihood of discovery. While these shortcomings may be ameliorated to some extent by the provision allowing IRS to waive the penalty on a showing of "reasonable cause" and "good faith," this waiver authority does not adequately address these shortcomings.

Other alternative standards in effect would require greater effort or care from the taxpayer than a reasonable care standard. These alternatives include such possibilities as undue hardship, best efforts, and an affirmative duty of diligence. Each would require IRS in administering a standard to make judgments based on expectations other than those which are reasonable under the circumstances, and accordingly would be quite difficult to administer consistently and correctly.

In summary, the Task Force concluded that the level of care that should be expected of taxpayers is one associated with traditional concepts of negligence, such as reasonable care. Reasonable care is intended to be a flexible standard permitting consideration of all facts and circumstances. Reasonable care requires that taxpayers exercise care in collecting information for an accurate return and in summarizing such information and entering it on the appropriate form. This duty is codified in section 6001 and the underlying regulations. Compliance with this standard is often a question of whether the taxpayer institutes an appropriate system of recording and reporting information. For example, the taxpayer's reporting system should record not only the amount of capital additions to plant and equipment but also the nature of the assets such that the proper period for cost recovery may be ascertained. The duty requires that taxpayers reevaluate the system when errors in reporting are found to prevent recurrence. In general, the Task Force believes that taxpayers understand this duty and the problems of voluntary compliance have not arisen out of failure to comply with this duty.

2. LEVEL OF ACCURACY. The second prong of the standard of behavior is the level of accuracy that taxpayers should, in the exercise of reasonable care, achieve if a position is not disclosed. This has been the focus of much of the controversy over the last decade. Possible alternatives include, generally, a litigating standard (the old reasonable basis standard or the more current realistic possibility of success if challenged); a standard requiring a substantial basis, but not an expectation of success (the substantial authority test of section 6661 is one such formulation); an expectation of success in the event of a challenge (the "more likely than not" level of tax shelter opinion lineage); or a certainty of success. Each of these alternatives has its pros and cons.

a. A LITIGATING STANDARD. In the view of the Task Force, the Code contains a litigating standard today. Whether the "reasonable basis" or the "realistic possibility of success" formulation is used, the desirable aspects of the litigating standard are three-fold. First, this level of accuracy is consistent with the general ethical expectations of the bar and accountants. Secondly, the standard is a practical one from the standpoint of its having been the subject of much discussion and debate over the years and its being a standard that both practitioners and taxpayers are comfortable they can meet. Thirdly, it provides a standard that is consistent with the taxpayer's right to litigate a questionable issue prior to payment of the deficiency related thereto.

On the other hand, the history of the reasonable basis standard indicates that it has serious deficiencies. In particular, the standard does little to encourage voluntary compliance. It encourages the continuation of the audit lottery, provides a climate in which problems such as abusive tax shelters can flourish, encourages an adversarial approach to tax matters, and generally encourages taxpayers to understate their probable tax liabilities on their returns. Perhaps a tougher regime of understatement penalties is a necessary corollary to this level of accuracy.

b. SUBSTANTIAL AUTHORITY. A level of accuracy that requires a substantial basis for a position would be higher than a litigating position but lower than a "more likely than not" position. It principal virtue is in reducing the opportunity for the audit lottery by requiring a substantial basis before an undisclosed position can be taken. Its principal shortcomings are that it is technical in nature and thus difficult for the nonprofessional to understand; it lacks definition and thus its application is uncertain; and it still permits a taxpayer to take an undisclosed position that the taxpayer does not believe correct, thus encouraging, though to a lesser extent, disrespect for the value of voluntary compliance and accurate self-assessment.

c. MORE LIKELY THAN NOT. The "more likely than not" standard would require disclosure of a position unless it was more likely than not to prevail. Such a standard would fully support accurate self- assessment by permitting the taxpayer to take undisclosed return positions only if he believed that they were likely to prevail. The standard is easily explained to the nonprofessional, unrepresented taxpayer as a reasonable belief that the return is correct. Concerns with this standard would include the concern that the complexity of the law would make it difficult to determine in some situations whether a position was more likely than not, that disclosure would be excessive, and that the standard would be inconsistent with standards of professional care.

d. CERTAINTY OF SUCCESS. Requiring certainty of success is the highest standard possible. Given the complexity of our tax system, the Task Force believes that such a standard is not feasible.

3. DISCLOSURE. Unless the levels of care an accuracy adopted in a standard of behavior for undisclosed positions closely conform to that required for the prepayment litigation of a position, the right to litigate an arguable position before paying must be preserved by permitting such positions to be taken, provided they are disclosed. Since the Task Force strongly believes that the desirable level of accuracy is higher than that required for the litigation of a position, the standard adopted must permit the taxpayer to take a litigable position (and thus be able to litigate an issue before payment) provided that such issue is disclosed.

C. CONCLUSION.

The Task Force believes that any of the levels of accuracy suggested above can be reconciled with the right of a taxpayer to litigate an arguable position before payment through the device of disclosure. No disclosure requirement would exist if the level of accuracy expected were at the reasonable basis level, because this is the same as the standard for a prepayment contest. However, the Task Force believes that disclosure is a reasonable tradeoff for one of the higher standards.

The Task Force believes that any of the levels of accuracy suggested above can be reconciled with the professional ethical obligations of attorneys and accountants by providing that the level of care expected in filing a return is one of reasonable care -- the classic negligence standard.

Finally, the Task Force is of the view that the level of accuracy to which taxpayers should aspire in exercising reasonable care falls in the "more likely than not" category. This is the only standard that truly supports the goals of a voluntary compliance system by encouraging taxpayers to file a return reporting the liability that they believe to be correct. Given limited audit coverage and the complex factual situations of today, any other level of accuracy will necessarily encourage taxpayers to underreport their liabilities and leave IRS in the position of policing a perfectly legal "catch me if you can" standard of behavior.

Based on these considerations, the Task Force concluded that a taxpayer should try to file a return accurately reporting his tax liability. "Trying" in this context should be defined as exercising reasonable care under the circumstances. A return should be treated as "accurate" if each position on the return is either more likely than not to prevail or is a litigable position that is disclosed. "Litigable" in this context should mean that the position has a realistic possibility of success if challenged.

IV. DESCRIPTION OF THE CURRENT PENALTIES.

Three primary penalties relate to accuracy: the negligence, fraud, and substantial understatement penalties. Other penalties relate to particular types of errors made on returns (e.g., valuation overstatements and understatements, and interest on substantial understatements attributable to tax-motivated transactions), or to the activities of preparers and promoters.

A. THE PRIMARY PENALTIES.

1. NEGLIGENCE. The negligence penalty in section 6655(a) is 5 percent of the amount of an underpayment if any portion of the underpayment is attributable to negligence or disregard of the rules and regulations. ¹⁶ The 5 percent rate applies to the entire underpayment, not merely that portion attributable to the taxpayer's negligent conduct. ¹⁷ The underpayment is the excess of the amount of tax determined to be due over the amount shown on a timely filed return. Section 6653(c)(1). Thus, if a taxpayer's return is delinquent, the amount of the underpayment is the entire tax liability for the year, regardless of the liability set forth on any return eventually filed. The negligence penalty does not apply to a fraudulent underpayment; ¹⁸ however, it may overlap with the substantial understatement penalty. Under the 1988 Act, interest on the penalty runs from the due date of the return. ¹⁹

As explained above, negligence requires a breach of both a level of care and a level of accuracy. The level of accuracy associated with the negligence penalty is that a reasonable basis exists. The discussion in the prior section of this chapter focused upon this aspect of the negligence penalty. The discussion in this portion deals with the levels of care.

Negligence is a term borrowed from tort law and may be generally defined as the failure to exercise the care that a reasonable and ordinarily prudent person would use under the circumstances. ²⁰ The Internal Revenue Manual defines negligence as "the omission to do something which a reasonable person, guided by those considerations which ordinarily regulate the conduct of human beings, would do, or doing something which a prudent, reasonable person would do or would not do." ²¹ Concern that the negligence penalty was not always applied when was justified prompted Congress to add section 6653(a)(3) in 1986. This provision augmented the general definition of negligence to include any failure to make a reasonable attempt to comply with the provisions of this title, and defined the term "disregard" to include any careless, reckless, or intentional disregard of rules and regulations. ²²

Although negligence generally depends an upon evaluation of all the facts and circumstances surrounding an underpayment, in two situations Congress requires automatic assertion of the penalty. Section 6653(f) penalizes certain failures to report straddles and section 6653(g) penalizes failures to report income shown on an information return, the understatement attributable to such failure is due to negligence unless the taxpayer proves by clear and convincing evidence that the failure was not due to negligence.

Generally, the IRS establishes negligence by specifying the existence of a negligent act or acts. Upon making such a finding, the taxpayer must rebut generally, by a preponderance of evidence, the IRS determination. In general, a taxpayer who relies in good faith on the opinion of a tax advisor is found to have exercised reasonable care so long as the taxpayer supplied the advisor with all the relevant information. ²³ On the other hand, where the taxpayer's duty is unambiguously stated in a statute and requires no special training or effort to ascertain and to see that the duty is discharged, reliance on a tax advisor may not be a defense. ²⁴

The effect of disclosure on the existence of negligence is unclear. At least one authority argues that complete disclosure negates the existence of negligence. ²⁵ No case, ruling, or regulation explicitly takes that position, however.

2. FRAUD. Section 6653(b) imposes a penalty of 75 percent of the portion of an underpayment attributable to fraud. ²⁶ Under the 1988 Act, interest on the penalty runs from the due date of the return.

Neither the Code nor regulations contains a definition of fraud. Civil tax fraud consists of actions taken by the taxpayer that are intended to evade a tax known or believed to be due. ²⁷ The Internal Revenue Manual requires the IRS to "establish that a part of the deficiency is due to a false material representation of facts by the taxpayer and that he/she had knowledge of its falsity and intended that it be acted upon or accepted as the truth." ²⁸ Unlike other accuracy penalties, the IRS has the burden of proving fraud by "clear and convincing evidence." ²⁹ If a portion of an underpayment is shown to be attributable to fraud, the entire underpayment is treated as attributable to fraud except to the extent that the taxpayer establishes the contrary.) ³⁰ Imposition of the fraud penalty prevents application of the negligence penalty to that portion of the underpayment attributable to fraud. If, only fraud is alleged and the taxpayer's actions were merely negligent, the negligence penalty may not be applied. Special rules relate to innocent spouses who join in the filing of a fraudulent joint return. ³¹

3. SUBSTANTIAL UNDERSTATEMENT. The substantial understatement penalty in section 6661 is 25 percent of the amount of any substantial understatement of income tax. ³² The term a substantial understatement" means an understatement that exceeds the greater of (i) 10 percent of the tax required to be shown on the return for the taxable year or (ii) $5,000 ($10,000 in the case of corporations). Section 6661(b). The amount of the understatement is reduced by any understatement attributable to positions for which the taxpayer had substantial authority or, with respect to items not attributable to a tax shelter, any position that the taxpayer adequately disclosed. Section 6661(b)(2)(B). If the item involves a tax shelter, in addition to the existence of substantial authority, the taxpayer must reasonably believe that the position taken is more likely than not correct. ³³

The IRS may waive all or any part of the penalty if the taxpayer shows that there was reasonable cause for the understatement and that the taxpayer acted in good faith. Section 6661(c). It is not yet clear whether failure to exercise this waiver authority is subject to judicial reviews, or, if what the appropriate standard for review (i.e., a de novo review or review for an abuse of discretion) is.

Substantial authority lies between a more likely than not standard and the reasonable basis standard that applies to the negligence penalty. ³⁴ Whether substantial authority exists depends upon whether the weight of authority is substantial in comparison to contrary authorities. /35 Authority for this purpose includes the Code and other statutory provisions, temporary and final regulations, court decisions, administrative pronouncements treaties, and Congressional intent as expressed in Committee Reports and floor debates. ³⁶ Excluded are Joint Committee on Taxation General Explanations ("Blue Books"), proposed regulations, private rulings (including general counsel memorandum), and conclusions stated in treatises, periodicals and opinions of tax professionals.

If the taxpayer files an amended return before the IRS first contacts the taxpayer, the IRS will waive any penalties that would have been imposed had the additional amount of tax or the additional disclosure been made on the taxpayer's original return. ³⁷ Certain taxpayers subject to frequent and expected audits may file such amended returns or provide additional disclosure for a brief period of time after being contacted for audit. ³⁸ In contrast, the filing of an amended return may have no affect upon the potential imposition of the fraud or negligence penalty. ³⁹

B. SECONDARY PENALTIES.

A variety of additional penalties relate to specific inaccuracies or causes of inaccuracies. Some are justified by the need to provide a way to compute an accuracy penalty; others merely increase the amount of the accuracy penalty for specific errors. Some of these penalties provide for a standard of conduct or for waiver that differs from the standard set under the primary penalties.

1. VALUATION PENALTIES. Section 6659 provides a penalty of 10 to 30 percent an underpayment to the extent that an underpayment by an individual, closely held corporation or a personal service corporation is due to a valuation overstatement. The penalty rate depends upon the relative amount of overvaluation claimed. At a minimum, in order to be applied the valuation claimed must exceed 150 percent of the correct valuation and the amount of the understatement must be at least $1,000. Sections 6659A and 6660 provide similar penalties with respect to underpayments due to an overstatement of pension liability and underpayments of estate or gift tax due to an valuation understatement, respectively. The IRS has authority to waive any of these misvaluation penalties if there is a reasonable basis for the valuation and the claim was made in good faith. As with the waiver provision under section 6661(c), it is not clear whether refusal to waive is reviewable by the courts or the appropriate standard of review.

Special rules exist under section 6659(f) with respect to valuation errors made on property (other than certain marketable securities) on which the taxpayer claims a charitable contribution deduction. In that case, the penalty in section 6659 is a flat 30 percent if the valuation claimed is at least 150 percent of the correct value. ⁴⁰ In addition, the IRS may not waive the penalty unless the valuation claimed is based upon a "qualified appraisal" by a "qualified appraiser" and the taxpayer made a good faith investigation of the value of the contributed property. ⁴¹ Inaccurate appraisals may subject the appraiser to penalties under section 6701, aiding and abetting an understatement of tax. While section 6661 does not apply to that portion of an understatement on which a penalty is imposed under section 6659, section 6661(b)(3), the overvaluation penalty may be imposed along with the fraud and negligence penalty. Indeed, a large misstatement of value claimed on the return may be evidence of negligence in preparing a return. Unlike the substantial understatement penalty, no mechanism permits waiver if the item is disclosed.

Some difficulties in applying section 6659 have involved determining what portion of an understatement is attributable to the valuation error. For example, in Todd v. Commissioner, 89 T.C. 912 (1987), the IRS argued alternatively that no deduction was allowed for depreciation because the property was not placed in service during the taxable year, and that the value claimed substantially exceeded the correct value. Holding for IRS on the former argument, the Tax Court refused to impose a section 6659 penalty since the understatement was attributable to a non-valuation issue.

2. OTHER PENALTIES. Another class of penalties function to provide a method for the computation of a penalty when the primary penalties do not provide an appropriate manner of calculation. Nevertheless, in many cases, these penalties differ from the primary penalties in the manner of assertion or in the level of care required.

One example of this type of penalty is section 6013(b)(5), which applies when a taxpayer or his spouse file inaccurate separate returns and later file a joint return. If the inaccurate separate returns were negligent, the provision applies a penalty of 5 percent of the portion of the excess of the joint liability over the sum of the separate liabilities to the extent that such excess was attributable to negligence. Section 6013(b)(5)(A)(ii) provides for a similarly computed penalty of 50 percent on the portion of the excess due to fraud. While these penalties are similar to the primary negligence and fraud penalties, there are important distinctions. To the extent that the amount of the understatement in the separate returns is offset by the benefit of filing a joint return, the penalty does not apply. Further, these provisions never contained an interest-based element similar to the pre-1988 negligence and fraud penalty, and the fraud portion of the penalty was neither increased from 50 to 75 percent nor targeted in 1986 when the section 6653(b) penalty was increased.

Section 6693(b) provides a $100 penalty for any taxpayer who overstates the amount of nondeductible contributions made to an IRA unless the overstatement is due to reasonable cause. The overstatement of nondeductible contributions in a taxable period may not result in an immediate overstatement of tax. Section 6693(b) was added by the 1986 Act and there are no recorded cases or rulings that indicate whether reasonable cause differs from a general negligence standard in this area. Unlike most other accuracy penalties, this penalty is not subject to deficiency procedures.

Section 6656(b) provides a 25 percent penalty on any claims based upon an overstated federal tax deposit unless such overstatement is due to reasonable cause and not willful neglect. Section 6675 imposes a penalty of 2 times any excessive claim for the use of nontaxable fuel, subject to waiver for reasonable cause. No authorities distinguish the standard of care under these two penalties from the standard of care in any of the primary penalties.

Section 6702 imposes a penalty of $500 on any frivolous income tax return. A frivolous return is a document that purports to be a return but lacks the information necessary to judge the substantial correctness of the self-assessment or appears on its face to be an inaccurate self-assessment. The penalty applies if the taxpayer's position is frivolous or the purpose of the document is to delay or impede the administration of the tax laws. In some instances, the penalty in section 6702 is the only penalty that may apply to a "tax protester" return if, for example, the taxpayer has satisfied the tax liability through withholding.

Section 6621(c) provides that the interest rate on deficiencies attributable to tax motivated transactions is 120 percent of the normal deficiency interest rate. The purpose of this provision was to encourage taxpayers to settle disputes rather that delay through litigation in the Tax Court. ⁴² The definition of a tax-motivated transaction specifically includes a valuation overstatement in section 6659. ⁴³ Section 6709(a) imposes a penalty of $1,000 for making a material misstatement with respect to a mortgage credit certificate if such misstatement is due to negligence. Section 6709(b) increases the penalty to $10,000 if the material misstatement is due to fraud.

C. PREPARER AND PROMOTER PENALTIES.

The preparer penalties of sections 6694 and 6695 were added by the Tax Reform Act of 1976. Section 6694(a) provides a penalty of $100 if any part of any understatement of a liability is due to the negligent or intentional disregard of the rules and regulations by a preparer. Section 6694(b) provides a penalty of $500 if any part of any understatement of liability is due to willful attempt to understate the liability. The penalty is abated if there is in fact no understatement. Section 6694(d).

The 6694(a) penalty is applicable in a manner similar to the existing negligence penalty. ⁴⁴ Thus, a preparer must exercise the care that a reasonable, prudent person would use under the circumstances. ⁴⁵ Under current procedures, the proposal of a penalty under section 6694 results in a referral to the Director of Practice of the IRS. Nevertheless, isolated errors, even though they may subject the preparer to a penalty, do not result in disciplinary action or removal from practice before the IRS. The preparer penalties were not amended when the substantial underpayment penalty was enacted in 1982.

A series of miscellaneous penalties set forth in section 6695 support of the duties of preparers that are stated elsewhere in the Code. Section 6695(a) provides a penalty of $25 for the failure to furnish the taxpayer a copy of his return as required by section 6107(a). Section 6695(b) provides a $25 penalty for failure of a preparer to sign a return. Section 6695(c) provides a penalty of $25 if the preparer fails to include his TIN on the return as required by section 6109(a)(4). Section 6695(d) provides a penalty of $50 (with a maximum of $25,000 in any return period) for failure to maintain a list of tax returns prepared as required by section 6107(b). Section 6695(e)(2) provides a penalty of $5 for failing to include required information on an information return. None of the penalties in section 6695(a) - (e)(2) apply if it is shown that the failure to comply is due to reasonable cause and not willful neglect. Section 6695(f) imposes a penalty of $500 on any preparer who endorses or negotiates a refund check.

Section 7407 permits the court to enter an injunction against a taxpayer involved in activity subject to penalty under section 6694 or 6695, misrepresenting eligibility to practice before the service or his experience or education as a preparer, guaranteeing the payment or a refund or the allowance of any credit or engaging in fraudulent or deceptive conduct which substantially interferes with the proper administration of the internal revenue laws.

In 1982, Congress added section 6701 to provide a civil penalty for aiding and abetting the understatement of tax. The provision was modeled after a criminal penalty in section 7206(2). Section 6701 applies a penalty of $1,000 ($10,000 in the case of a document relating to a corporation) to aiding or abetting in the preparation of a return or document with knowldge that it will be used to understate the liability of the taxpayer.

Section 6700 imposes a penalty on certain organizers or promoters of tax shelters who make a false or fraudulent statement as to any material matter or make a gross valuation overstatement as to any material matter. The penalty is the greater of $1,000 or 20 percent of the gross income to be derived from the activity. The penalty dealing with gross overvaluations may be waived upon a showing of a reasonable basis for the valuation and that the valuation is made in good faith.

Section 6708 provides a penalty for failure to maintain a list of investors required under section 6112 of $50 per investor (up to a maximum of $100,000) unless such failure is due to reasonable cause and not willful neglect.

Section 7408 provides authority to issue an injunction against a person who has engaged in conduct subject to the penalties of section 6700 or section 6701.

V. HOW THE CURRENT PENALTIES SUPPORT THE NORMATIVE STANDARD.

In some ways, the current penalties poorly support the proposed standard of behavior. The confusion over a standard explains some of these difficulties, as does the rapid growth in the number of penalties and the lack of coordination among them. Set forth below is an evaluation of the penalties based upon the factors set forth in Chapter 3: fairness, effectiveness, comprehensibility, and administrability.

A. FAIRNESS.

1. EQUITY. To determine whether existing accuracy penalties treat similarly situated taxpayers similarly, one must first group taxpayers according to similarity. Based on the proposed standard, taxpayers who exercise reasonable care to file an accurate return are similarly situated: they should not be penalized. On the other hand, taxpayers who fail to exercise such reasonable care should, subject to competing considerations such as administrability, be penalized. Viewed in this way, the existing accuracy penalties have a variety of shortcomings.

Existing penalties do not consistently separate taxpayers into groupings based on whether reasonable care has been exercised. With some penalties, the taxpayer's conduct is ignored in favor of objective considerations. The substantial understatement and the valuation penalties are examples of penalties that are imposed based upon objective criteria other than reasonable care. In other areas, the statute establishes procedural barriers to treating taxpayers not similarly situated differently, such as the evidentiary presumption of section 6653(f) that treats the failure to file a form as a conclusive presumption of negligence. Conduct that would seem similar is treated differently in other ways as well. Thus, for example, section 6661 treats misconduct with respect to legal issues more harshly than similar factual issues, and valuation questions are singled out for special treatment in sections 6659, 6659A, and 6660, while other issues are ignored.

Even when the conduct of two taxpayers is identical -- they exercise the same degree of care and have the same degree of confidence with respect to the same issue involving the same amount of tax -- one taxpayer may be penalized and one may not. For example, section 6661 applies only to understatements exceeding both ten percent of the tax shown on the return and $5,000 ($10,000 in the case of corporations). The Task Force recognizes that the amount of tax related to a position may be relevant to determine whether the taxpayer exercised reasonable care with respect to that position; however, making the size of the item a necessary component for the assertion of a penalty creates inequities.

Further, distinctions are made based on the role of the person in the tax controversy. Thus, while taxpayers may be subject to sanction under section 6661 for a failure to have substantial authority, the preparer who advised the taxpayer with respect to the return is subject to no sanction whatsoever. In the area of information reporting, inaccuracies arising out of the same sort of conduct may or may not be penalized, based on what type of information return is required. Thus, inaccuracies on interest or dividend reports may be punished on a standard approaching strict liability while inaccuracies of other types of reports go unpunished unless negligence can be shown. ⁴⁶

One can argue that these contradictions are justified based on the need for differing standards of behavior for differing accuracy issues. Arguably, for example, the need for accurate information reports in the interest and dividend area requires a higher standard of behavior than that for other reports; taxpayer conduct is appropriately subject to higher expectations than that of preparers; and so forth. Such varying standards, however, have significant costs, including the complexity that arises from the need to deal with many different standards rather than one, the attenuation of normative meaning that follows from a willingness to promulgate varying standards for classes of behavior that are similar, and the administrative difficulties that arise in attempting to apply so many varying legal rules to a large number of cases.

The Task Force is of the view that a single standard of behavior dividing taxpayers who are subject to penalty from those who are not is sufficient, provided that such standard focuses on the general expectations of care and certainty that the tax system has of a taxpayer, practitioner, or payor rather than on the specific procedures or acts that are required. The Task Force is also of the view that such a standard of behavior should provide the key issue in any proceeding involving the assertion of a penalty, although presumptions and objective tests may provide a useful administrative tool supporting such a standard.

2. PROPORTIONALITY. Assuming that the understatement penalties operate with equity, and thus that only taxpayers who violate the standard of behavior established are subject to penalty, one is left with the question of whether those identified as in violation of the standard are penalized in proportion to their departures from the standard. This focuses on whether the penalty reflects the culpability of the taxpayer and the harm that the noncompliance causes or may cause. A number of problems exist with the current penalty structure.

a. TARGETING. An accuracy penalty is "targeted" if the amount of the penalty is computed by reference solely to the particular items as to which the standard of behavior was breached. Thus, section 6661 is targeted because it applies only with respect to those undisclosed positions lacking substantial authority, while the negligence penalty of section 6653(a) is untargeted because any single negligent item causes the penalty to apply to all items in the deficiency, including those with respect to which the taxpayer was not negligent.

The targeting of some penalties and not others necessarily causes illogical results. This is aggravated by the fact that a targeted penalty must ordinarily have a higher percentage rate in order to be as effective as an untargeted penalty, due to the potentially smaller base from which it is computed. Thus, even though negligence is a more serious departure from accuracy than the failure to have substantial authority, it is penalized at an untargeted 5 percent rate while the latter is subject to a targeted 25 percent rate. Proportionality would be best achieved in a penalty regime in which all penalties are targeted or all penalties are untargeted.

Whether targeting is preferable to the alternative is a matter of legitimate debate. Targeting penalties gives rise to administrative complexity, while arguably achieving better proportionality by preventing sometimes irrelevant facts from affecting the result. ⁴⁷

b. INTEREST-AFFECTED COMPUTATIONS. Some accuracy penalties include interest-affected amounts. Thus, for example, the tax motivated transaction penalty of section 6621(c) imposes a higher interest charge on delayed payment of certain deficiencies subject to penalty. Delay in payment, for which many legitimate reasons may exist, seems irrelevant to the taxpayer's culpability or the harm that noncompliance with expectations of accuracy may cause. While interest is an appropriate charge to take time-value considerations into account and penalties should certainly bear interest from some point, the use of time-value concepts in setting the amount of an accuracy penalty seems illogical.

c. SIMILAR PENALTIES FOR SIMILAR ACTS. In many instances, the accuracy penalties ignore general measures of proportionality (culpability and harm) in favor of a specific focus on particular types of misconduct. Negligent or fraudulent separate returns that are superseded by a joint return are punished based on the negligence and fraud penalties as they existed prior to recent changes. See I.R.C. section 6013 (__). Valuation problems are subject to a regime different from undisclosed positions without substantial authority. Compare I.R.C. section 6661 with section 6659. Other factual issues are arguably treated differently from the valuation and legal issues covered in sections 6661 and 6659, even though the amount of the understatement and the taxpayer's culpability are similar. In the absence of compelling arguments to the contrary, disparate treatment in these areas should be avoided.

d. STACKING. Two or more of the accuracy penalties may apply to a single instance of inaccurate reporting. For example, the substantial understatement and negligence penalties may both apply to some negligent understatements but not to others. A similar situation exists with the overvaluation and negligence penalties. Applying multiple penalties would arguably be appropriate if the penalties were designed to operate in a logical way and this relatively complex approach served an important purpose. However, this stacking of accuracy penalties at present seems to operate illogically and serve no important policy that could not be served in a simpler way. Stacking has a haphazard impact on proportionality unless carefully coordinated and thus should be avoided in the absence of compelling arguments to the contrary.

e. DELINQUENCY PENALTIES. The late filing of a return may give rise both to a negligence penalty and to one or more of the delinquency penalties, such as failure to file the return or pay the tax. While two separate instances of noncompliance may be involved, justifying two separate penalties, the negligence penalty applies even to taxes that are disclosed and paid late due to the expansive definition of underpayment in section 6653(c). This arguably constitutes the imposition of a negligence penalty on conduct that is really a delinquency issue. In any case, the severity of these multiple penalties may rise very high.

f. ABSENCE OF DEFICIENCY. For some accuracy problems, no understatement exists or the understatement is difficult to determine. For example, frivolous returns filed by a tax protester often involve no assertion of tax due; accuracy problems that a payor may experience in filing information returns involve no tax liability of the payor. In such cases, the penalty system must determine some other measure of the penalty, although the general expectation of accuracy established by the standard of behavior suggested would seem applicable. Proportionality in these cases may turn on factors peculiarly applicable to the particular situation. For example, harm caused by failure to file accurate information returns may be best determined based either on the number of inaccurate returns or the amount of the items that should have been reported in such returns.

g. DIRECTIONS. The foregoing problems could be resolved through a system of accuracy penalties that is coordinated and progressive, keyed to broad indicators of culpability and harm. One might argue that culpability should be broken into three pieces: negligent conduct, intentional conduct, and fraudulent conduct. At present the tax system does not seem to treat, in the accuracy area, intentional conduct differently from negligent conduct. Whether such a distinction is needed is unclear.

With respect to the harm that failure to comply with expectations of accuracy causes, one might make the argument that departures from accuracy in and of themselves cause harm and thus should be penalized without regard to culpability. Given the complexity of many accuracy issues, the Task Force is of the view that this would be inappropriate at the present time. One key indicator of harm should be the amount of the tax at issue. A second key indicator is the extent of the departure from the level of certainty expected. Thus, a position that fails to meet the accuracy expectation but has a realistic possibility of success if challenged should be treated less harshly than a position that has no reasonable basis.

B. EFFECTIVENESS.

1. ADEQUATE SEVERITY. Determination of the size of a penalty necessary to promote voluntary compliance yet not so large as to be unfair, is a most difficult judgment to make and support. The IRS does not currently collect the empirical data necessary for the Task Force to evaluate the appropriateness of a penalty's severity, and such an evaluation would be very difficult to do in a scientific way in any case. Thus, decisions regarding the adequacy of a penalty must presently be based on expert opinion.

Effective deterrence requires that the amount of a penalty would take into account the probability of audit times and the probability that an issue would be discovered if the return were audited. Given that the IRS audits less than 2 percent of the returns each year, this indicates that the rates for penalties need to be fairly high. On the other hand, moral and ethical dimensions of filing an accurate return would indicate that this determination need not be based solely on an economic analysis. The statement of an expected standard of conduct as a normative rule may have the effect of increasing the moral and ethical support for voluntary compliance, thus decreasing the need to raise the penalty rates.

The Task Force believes that the current negligence penalty of 5 percent of the understatement is generally not severe enough by itself to provide adequate deterrence. Some adjustment may also be required to reflect proportionality and target. On the other hand, the penalty in section 6661 has unfortunately been wrapped in controversy over the reasons for the increase from 20 to 25 percent and the view that the increase was unfair because it could increase punishment for completed acts. In the general discussion of penalties, the Task Force rejects the use of penalties to raise revenue and does not support any penalty provision the purpose of which is other than to promote voluntary compliance. Nevertheless, the Task Force was unable to determine that the determination to raise the rate to 20 percent based upon a belief "that the current level [10 percent] of the substantial understatement penalty provides an insufficient deterrent. . . ." ⁴⁸ was in error.

Penalties that are too small may be an inadequate deterrent to noncompliant conduct. The current $5 penalty for failure to include a dependent's TIN may be an example of such a penalty. Furthermore, because of difficulties in administration of such small penalties (for example, it is difficult to justify collection action if the taxpayer does not voluntarily pay), the Service may not be able to devote adequate resources to the penalty, which in turn reduces the penalty's deterrent effect.

2. ENCOURAGING REMEDIAL ACTION. A common complaint by taxpayers is that penalties are neither reduced nor abated for first-time offenders. One practical reason for the failure to adopt that position is the lack of data with respect to taxpayers who have previously been assessed penalties or been excused from the potential assertion of penalties. The Task Force believes that a need for a first-time offender waiver is substantially lessened where it is clear that no penalty will be applied in the absence of negligence. Furthermore, even if such offenders were identified, the Task Force is concerned whether allowing leniency for first time offenders would undermine the deterrent effect of the penalties. This concern is heightened in a system where only a small portion of returns are subject to audit.

The current penalties relating to accuracy provide neither an increased penalty for repeating noncompliant behavior nor any abatement for a voluntary correction. ⁴⁹ The substantial understatement regulations require waiver of that penalty if the taxpayer files a voluntary amended income tax return. This waiver offers substantial encouragement for the filing of correct returns in those situations where the harm to the system is minimized. To encourage remedial action, taxpayers should have a continuing obligation regarding the accuracy of any return and receive some benefit from such filing.

C. COMPREHENSIBILITY.

The Task Force recognizes that some of the current penalty provisions relating to accuracy are difficult to comprehend. This difficulty may relate to whether the penalty expresses a standard of behavior or a toll charge, whether multiple penalties apply to the same incidence of conduct, or confusion as to the amount of the penalty. This complexity of the accuracy penalties adversely affects the ability of these penalties to increase voluntary compliance.

As previously stated, penalties are more effective if, in addition to a financial aspect, the penalty imposes a moral or ethical sanction against one who is found to violate the standard. A penalty will not achieve a moral and ethical dimension if the penalty is not understood, because taxpayers will view sanctions for violation of standards that are not understood to be unfair and fairness is viewed as a necessary ingredient to any normative standard.

In addition, complexity decreases the ability of IRS to administer the laws. Thus, complexities should be eliminated unless justified as serving some additional purpose, e.g., increasing equity, proportionality or effectiveness. Many of the provisions that are considered complex have been discussed above, such as stacking of multiple inaccuracy penalties, and different bases for negligence and other accuracy penalties.

Another striking example of complexity involves the standard of behavior with respect to the numerous miscellaneous accuracy penalties Congress has provided for particular types of errors. These penalties each state a standard for imposition or waiver. Without explanation, Congress has set forth a variety of formulations of what appears to be a negligence standard, but with slight variations. For example, the penalty in section 6656(b) "shall not apply" if the error "is due to reasonable cause and not due to willful neglect"; the penalty in section 6660 "may be waived" if the taxpayer shows that the taxpayer's position had "a reasonable basis . . . and the claim was made in good faith"; and the penalty in section applies unless the taxpayer shows that the error was due to "reasonable cause." The Task Force is not aware of any explanation for these variations of a standard.

Other complexities involve differing dates from which interest on penalties begins to run, differing methods for proposing or challenging the proposal of penalties, and stacking of penalties relating to accuracy with penalties for failure to file a timely return. None of the above complexities has been justified to the satisfaction of the Task Force. Absent such justification, these provisions should be repealed and the inconsistencies resolved in a single standard with consistent administrative positions.

In addition to the complexity of the penalty provisions, an additional factor in comprehensibility is the complexity of the law that sets a taxpayer's liability. The Task Force believes that the breakdowns in compliance that led to the enactment of the substantial understatement penalty were related to the increasing complexity and ambiguity in the tax laws. Where taxpayers may take aggressive positions on a return and limited resources are devoted to compliance, it can be anticipated that both Congress and the IRS will be more detailed, specific, and complex as to the substantive law in anticipation of taxpayers' taking such aggressive positions. Arguably, the reasonable basis standard has the effect of drawing the limited resources of the IRS to rulemaking and away from compliance activities. It also increases the urgency of getting detailed guidance to taxpayers before returns are filed. The IRS may be able to more efficiently allocate its resources and be able to provide less burdensome rules if the standard of conduct were raised.

D. ADMINISTRABILITY.

1. ADMINISTRATIVE DISCRETION. With respect to the negligence penalty, the IRS is able to exercise its administrative discretion through the reasonable care standard. Since such standard is based upon all the facts and circumstances, a penalty would be proposed only if, based upon the facts and circumstances, the agent believed that the taxpayer failed to comply with the standard of conduct. This grants the agent broad discretion over when to propose a penalty.

With respect to the balance of the accuracy penalties, including section 6661, the IRS is provided with administrative discretion through good faith, reasonable belief (or similar) waiver standards. In section 6661, a penalty is proposed if the taxpayer fails to meet an objective standard, substantial authority. The penalty may be waived if the taxpayer shows he had a reasonable belief and acted in good faith. Penalties that separate compliant from noncompliant taxpayers by use of a waiver provision require the administrator to propose the penalty before considering whether the taxpayer violated the standard of behavior, then abate if it is found the taxpayer met the appropriate standard. While this approach clearly is cost- efficient and may be fair with respect to the comparatively straight- forward taxpayer obligations of filing a return and paying the tax, it is less clearly appropriate with respect to the accuracy penalties.

There are two particular problems with respect to the use of waiver provisions for accuracy penalties. Because of the fact that a large number of taxpayers may be expected to have understatements not caused by a failure to comply with the proposed standard of conduct, a large number of taxpayers will be required to justify why a penalty should not be asserted against them. This creates additional friction between the IRS and taxpayers. In addition, use of a waiver provision often puts the agent in the position of proposing penalties and leaving waiver to some later stage in dispute resolution. Where the taxpayer is expected to exercise reasonable care, it is the agent closest to the facts who is best able to judge whether the taxpayer met the standard of conduct.

Although ideally the Task Force believes that the standard of behavior should be built into the initial screening process, the Task Force is mindful of the administrative benefits of a process that relies in part upon use of waiver authority. The Task Force believes that the problems with respect to waivers may be limited if the initial selection criteria is limited. Thus, the selection process may be biased to not catch noncompliant taxpayers to avoid causing undue burdens on compliant taxpayers. Furthermore, where the standard is reasonable care, those who are closest to the facts must understand their function and duty is not merely to propose penalties where a mathematical criteria is met, but to determine whether the taxpayer met the standard of conduct.

Administration of a reasonable care standard is difficult. The existence of reasonable care depends upon all the facts and circumstances; a reasonable care standard cannot be administered though formulas, checklists, or rote application of guidelines. Rather, administration of a reasonable care standard requires the IRS to weigh multiple factors. Nevertheless, a lack of guidance as to facts that are generally relevant hinders uniform administration of the penalty provisions and the ability to achieve equity. While the Task Force recognizes that a list of all factors that may be relevant is not feasible, Congress and the IRS each have a responsibility to provide taxpayers and administrators with guidance on whether and how commonly-encountered facts affect the determination of the presence or absence of reasonable care.

As noted above, the Task Force received comments that the IRS has failed to exercise its discretion with respect to the substantial understatement penalty. Some have alleged that as it is administered, the substantial understatement penalty is a no-fault penalty. That is, the taxpayer's effort and state of mind are not considered at any time by the IRS in determining whether the penalty applies. While such administrative practice would be in conflict with the existence of a waiver provision in section 6661(c), such a discrepancy might be expected in a situation where the attitude of many is that section 6661 does not state a standard of behavior. In addition, confusion may be based upon the existence of an objective standard for the penalty and a more subjective standard for waiver. The view that section 6661 does not state a standard of behavior would be reinforced by relatively sparse application of the waiver provisions.

An administrator is best able to exercise discretion when broad guidance from both the IRS and Congress has been provided. Such guidance should set forth not only the appropriate standard of conduct, but the criteria that should be considered in determining whether that standard has been met. Guidance should not, however, attempt to replace the judgment of administrators. The Task Force is concerned that administrator's judgment has been preempted by presumptions of noncompliance based upon a single objective fact. For example, section 6653(g) provides a presumption of negligence if a taxpayer understates certain income reported on information returns. In light of such presumption, current IRS procedures provide that computer-generated notices attributable to inability to match the reported income to the taxpayer's return will include a negligence penalty. No one can deny that the failure to report income included on an information return is indeed evidence of a lack of reasonable care. Nevertheless, there may be other factors that indicate that the taxpayer was not negligent yet the presumption limits the consideration of such factors. The provision also increases the standard for overcoming the presumption of negligence to require the showing of clear and convincing evidence. By presuming negligence, IRS decreases its administrative costs, but at the cost of not focusing attention on the taxpayer's conduct that is at issue and that should be regulated. In addition, where the IRS has no discretion, it must devote its resources to the assertion and collection of the penalty. Because resources are limited, the IRS should have the discretion to devote its resources to those compliance programs that it believes will have the most positive impact on voluntary compliance.

2. NEUTRALIZATION OF SEVERE SANCTIONS. Sanctions seen as overly severe are often neutralized by a failure to enforce. While the Task Force has received no data indicating such phenomenon has occurred, there are penalties which in some circumstances are so severe as to raise legitimate concerns. One situation that may lead to the possibility of a "overly severe" penalty exist when the taxpayer was negligent with respect to a small portion of a very large understatement. Since the current penalty in section 6653(a) is not targeted to negligent conduct, the potential penalty may seem out of proportion to the misconduct. Another circumstance that may lead to neutralization involves stacking of multiple accuracy penalties (or filing, payment, and accuracy penalties).

The Task Force received comments that the substantial understatement penalty was overly severe. In part, the Task Force believes these comments may be grounded in the controversy concerning the reason for the increase. On the other hand, the section 6661 penalty was designed in part to limit taxpayer's ability to play the audit lottery. Given the current rate of audit of returns and the historic trend of the probability of audit, the Task Force believes that the current rate in section 6661 could be justified from a financial perspective. The Task Force lacks, however, data from which to draw definitive conclusions.

3. LIMITED RESOURCES. The final aspect of administrability is dealing with limited resources. Many of the criticisms meted out against the current penalties may be explained as attempts to balance other factors with the reality of the IRS' limited resources. The Task Force found that balancing fairness, effectiveness and comprehensibility with this reality may be the most difficult task both for designers of the system and for administrators.

For example, one factor that competes with limited resources is equity. A fairer provision often is more complex and, more importantly, requires the IRS to make more difficult distinctions between conduct. Thus, for example, proportionality would point to the need to distinguish intentional from negligent conduct. On the other hand, such distinctions are often difficult, and making these distinctions burn resources. Another instance where limited resources is involved relates to the use of objective factors as grounds to propose a penalty, rather than judging the conduct expected by the standard of behavior. Thus, it may be appropriate to infer the taxpayer's conduct based upon the presence of certain objective factors and rely upon waiver authority to prevent penalizing compliant taxpayers.

Targeting of the negligence penalty may be justifiable from a perspective of an equitable and proportional penalty, but targeting creates many administrative problems. It may be expected that even where one position was admittedly negligent, taxpayers may contest the application of the negligence penalty to ever other position taken on a return. Thus, the increase in equity may force the utilization of resource to proof of each such item where such resources may be better sent.

Penalties that are too small pose difficulties of administration. For example, administering the $5 penalty for failure to include a dependent's TIN may be a poor allocation of resource, since the penalty is probably too small to be effective and assertion utilizes scarce resources. Thus the IRS is forced to allow blanket waivers of the penalty, an action that may be incorrectly perceived by taxpayers as meaning the underlying statutory provision is uninportant.

The existence of several levels of penalties causes complexity in the assertion of penalties in litigation. The IRS must allege not only the most serious penalty potentially applicable, but also each lesser included penalty that may be applicable. This creates an undesirable administrative burden on the IRS.

VI. RECOMMENDATIONS.

1. STANDARD OF BEHAVIOR.

Taxpayers should be expected to try to file an accurate tax return. This means that taxpayers should exercise reasonable care to file a return for which each position is more likely than not to prevail. Positions not meeting this standard should be permitted on the return only if they are disclosed and they have a realistic possibility of prevailing if challenged.

2. THREE-TIER PENALTY.

The foregoing standard should be supported by two negligence penalties and one fraud penalty:

a. NEGLIGENCE PENALTY. The negligence penalty would apply if the taxpayer failed to try to file an accurate return. Thus, the penalty would apply only if

i. an undisclosed position on the return was not more likely than not to prevail AND

ii. the taxpayer took such position either intentionally or failed to exercise reasonable care in taking such position.

b. GROSS NIGLIGENCE PENALTY. The gross negligence penalty would apply only if

i. a position on the return did not have at least a realistic possibility of prevailing if challenged AND

ii. the taxpayer either took such position intentionally or failed to exercise reasonable care in taking such position.

c. FRAUD PENALTY. The fraud penalty would apply in the same circumstances in which it presently applies.

3. COORDINATION.

The three accuracy penalties should be coordinated, perhaps in a single Code section, as follows:

a. PROPORTIONALITY. The amounts of the penalties increase in proportion to the seriousness of the noncompliant conduct. For example, a schedule of 20, 50, and 100 percent would do this.

b. LESSER INCLUDED OFFENSE. An assertion of one penalty automatically includes an assertion of each lesser penalty.

c. SINGLE PENALTY APPLICABLE. Only the most severe applicable penalty can be collected.

d. ALL PENALTIES TARGETED. Each penalty is computed with respect to the same base. This requires that each penalty be targeted solely to that portion of the understatement as to which the noncompliant conduct occurred. To minimize administrative problems, once the IRS has established that one of the foregoing penalties applies to any portion of the understatement, the penalty should apply to the entire understatement unless the taxpayer establishes that the conditions of the penalty were not present with respect to a portion of the understatement.

e. INTEREST. Each penalty should bear interest from the same date. The Task Force believes that the most appropriate date is after notice and demand of the taxpayer is made for the penalty.

f. DELIQUENCY. If a return is filed late but before any compliance action, an accuracy penalty should not apply to any portion of the admitted liability set forth on such late-filed return.

g. DISCLOSURE. Consideration should be given to the possibility of expanding those items with respect to which reporting on the return is considered to be adequate disclosure. See Rev. Proc. 88-37, 1987-30 I.R.B. 31.

4. AMENDED RETURNS.

A taxpayer should be required to file an amended return when the taxpayer becomes aware that a previously filed return was materially incorrect at the time it was filed. Negligence penalties on the originally filed return should not be applicable if such negligence is corrected on an amended return before the beginning of compliance action by IRS. In the case of taxpayers who are routinely audited each year, presentation of amended return information at the inception of the audit would fulfill this expectation.

5. PREPARERS.

The following changes are recommended with respect to preparers:

a. STANDARD OF BEHAVIOR. Section 6694 should be amended to state that the preparer should exercise reasonable care to determine that the taxpayer's return complies with the taxpayer's standard of behavior set forth in the Code. The custom of the profession and the facts surrounding the matter at issue should normally guide the evaluation of reasonable care. To the extent possible, guidance concerning reasonable care should be issued to promote uniform application of the standard and to aid practitioners in developing their procedures. For example, further guidance with respect to office practices and procedures, such as the guidance in Revenue Rulings 80-262 through 80-266, should be considered.

b. COORDINATION WITH ACCURACY PENALTIES. Three levels of penalty should be established in section 6694, coordinated with the three accuracy penalties suggested in recommendation 2 above. The amount of the penalty would depend upon what level of accuracy was violated. A minimum penalty would apply if the preparer failed to exercise reasonable care to see that every undisclosed position on the return was more likely than not to prevail. A more severe penalty would apply if the preparer failed to exercise reasonable care to see that every position had a realistic possibility of success. The most severe penalty would apply if the preparer's conduct was willful or fraudulent. While data does not exist to permit the amounts of these penalties to be determined empirically, the Task Force recommends that the penalties be set at $100, $250, and $500.

6. CIRCULAR 230.

a. THE STANDARD. The rule in Circular 230 should be coordinated with the standard of behavior for taxpayers so that:

i. A practitioner may not advise that a tax position can be taken unless, in the exercise of reasonable care, the practitioner concludes either (a) that the position more likely than not would prevail if challenged, or (b) that the position has a realistic possibility of prevailing if challenged and the practitioner advises the client that disclosure is required.

ii. A practitioner may prepare or sign a return taking a position that is not more likely than not to prevail if challenged only if the position has a realistic possibility of success if challenged and is adequately disclosed.

b. IMPORTANCE OF REASONABLE CARE. In determining whether or not there is a violation, the existence of reasonable care by the practitioner should be the dominant consideration. Thus, referrals to the Director of Practice should be made only where the practitioner's conduct, separate from the taxpayer's conduct, is called into question. Consideration could be given to establishing an outside advisory group with whom the Director of Practice could consult on the issues of reasonable care and appropriate sanctions.

c. FACTORS. The Director of Practice should be directed to consider all of the facts involved, including the good faith nature of the advice; the guidance in legislation, regulations, proposed regulations, general counsel memoranda, actions on decisions, technical memoranda, rulings, case law, legislative history, Blue Book explanations, legal periodicals and treatises relative to a position; and the practitioner's review and analysis of the facts. In deciding a case, the Director of Practice should take into consideration whether a realistic possibility of success exists with respect to any undisclosed position, whether a pattern of negligence exists, and whether the practitioner's conduct was willful, reckless, or the result of gross incompetence. The purpose of such considerations is that isolated incidences of mere negligence would not result in suspension or disbarment, rather that such sanctions would be appropriate only for egregious misconduct.

d. COMMERCIAL PREPARERS. Whether the Director of Practice should have jurisdiction to sanction unenrolled commercial preparers in a manner similar to enrolled preparers should be studied.

7. OTHER ACCURACY PENALTIES.

The Task Force's recommendations on other penalties assume that the preceding recommendations are adopted.

a. REPEAL OF UNNECESSARY PENALTIES. Accuracy penalties targeting specific acts should be repealed unless the need for such separate penalties can be convincingly demonstrated. These include:

Section 6621(c) -- Interest on substantial understatements attributable to tax-motivated transactions

Section 6653(f) -- Failure to report unrecognized gain on position in personal property

Section 6653(g) -- Failure to include amounts shown on information return

Section 6659 -- Valuation overstatements

Section 6659A -- Overstatements of pension liabilities

Section 6660 -- Estate and gift tax valuation understatements

Section 6661 -- Substantial understatement of liability.

b. RECODIFICATION. All penalty provisions relating to accuracy should incorporate the standards set forth in the primary penalties. The following provisions should be recodified to clarify that they do not establish separate standards of behavior; rather, they merely provide a manner to compute the amount of the penalty:

Section 6013(b)(5)(A)(i) -- Negligence with respect to certain separately filed returns

Section 6656(b) -- Overstatement of federal tax deposit claims

Section 6013(b)(5)(A)(ii) -- Fraud with respect to certain separately filed returns

Section 6693(b) -- Overstatement of designated nondeductible contributions

Section 6674 -- Providing false statement to employees

Section 6675 -- Excessive claims with respect to the use of certain fuels

Section 6676 -- Failure to supply an identifying number

Section 6682 -- False information with respect to withholding

Section 6690 -- Fraudulent statement to plan participant

² Section 6653(b).

³ Reprinted in, B. Wolfman & J. Holden, Ethical Problems in Tax Practice 55, 57 (2d ed. 1985).

⁴ 23 Fed. Reg 9261, 9264 (November 29, 1958).

⁵ Section 6213.

⁶ ABA Comm. on Ethics and Professional Responsibility, Formal Opinion 85-352 (1985), reprinted in 39 Tax Lawyer 631, 634 (1986).

⁷ Staff of the Joint Committee on Taxation, 94th Cong., 2d Sess., General Explanation of the Tax Reform Act of 1976 35 (Comm. Print 1976), 1976-3 C.B. (Vol. 2) 1, 47.

⁸ See chapter 5, pages _____ - _____.

⁹ See J. Kurtz & Panel, Discussion on "Questionable Positions," 32 Tax Lawyer 13 (1978).

¹⁰ J. Mundheim, Remarks before the Securities Regulation Institute, reprinted in 15 Daily Tax Report J-1, J-2 (January 22, 1980).

¹¹ 49 Fed. Reg. 6719, 7116 (1984), Treasury Department Final Amendment to Circular 230 (31 C.F.R. Part 10) relating to Tax Shelter Opinions, section 10.33(a)(4).

¹² See Staff of the Joint Committee on Taxation, 94th Cong., 2d Sess., General Explanation of the Tax Reform Act of 1976, 345-47 (Comm. Print 1976), 1976-3 C.B. (Vol. 2) 1, 357-58.

¹³ ERTA section 722(b)(1).

¹⁴ ERTA sections 501(b), 722(a)(1).

¹⁵ TEFRA Section 325(a).

¹⁶ The Miscellaneous Revenue Act of 1988 (the "1988 Act") eliminated a provision that increased the negligence penalty by 50 percent of the interest on that portion of the understatement that was attributable to the negligent conduct.

¹⁷ Commissioner v. Asphalt Products Co., ___ U.S. ___, 107 S.Ct. 2275 (1987).

¹⁸ Section 6653(a)(2)

¹⁹ Section 1015 of the 1988 Act.

²⁰ See Marcello v. Commissioner, 380 F.2d 499, 509 (5th Cir. 1967, cert. denied, 389 U.S. 1044 (1968); Rev. Rul. 80-28, 1980-1 C.B. 304, 305.

²¹ IRM 4563.1(a).

²² H. R. Rep. 426, 99th Cong., lst Sess. 833-36 (1985), 1986-3 C.B. (Vol. 2) 1, 833-36.

²³ Hill v. Commissioner, 63 T.C. 225 (1974); see also United States v. Boyle, 469 U.S. 291, 251 (1985) ("When an accountant or attorney ADVISES a taxpayer on a matter of tax law, such as whether a liability exists, it is reasonable for the taxpayer to rely on that advice." (Original emphasis)).

²⁴ See United States v. Boyle, supra (executor could not rely upon attorney to excuse late filing of a return).

²⁵ See H. McCawley, Civil Tax Penalties, 441-2d Tax Mgmt. Port. A-14 (1986).

²⁶ The 1988 Act eliminated that portion of the fraud penalty that was computed by reference to interest on the portion of the underpayment attributable to fraud. Section 1015 of the 1988 Act.

²⁷ See, e.g., Mitchell v. Commissioner, 118 F.2d 308, 310 (5th Cir. 1941) (fraud is "actual, intentional wrongdoing, and the intent required is the specific purpose to evade tax").

²⁸ IRM 4563.41(1).

²⁹ Section 7454(a); Tax Court Rule 142(b).

³⁰ Section 6653(b)(2).

³¹ See section 6103(e).

³² Unlike the provisions of 6653(a) and (b), the substantial understatement rules do not apply to estate and gift or excise tax returns.

³³ Section 6661(b)(2)(C).

³⁴ Treas. Reg. section 1.6661-3(a).

³⁵ Treas. Reg. section 1.6661-3(b).

³⁶ Treas. Reg. section 1.6661-3(b)(2)

³⁷ Treas. Reg. section 1.6661-6(c).

³⁸ Rev. Proc. 85-26, 1985-1 C.B. 580.

³⁹ See Drieborg v. Commissioner, 225 F.2d 216 (6th Cir. 1955) (fraud); _______ (negligence).

⁴⁰ Section 6659(f)(1).

⁴¹ Section 6659(f)(2). The terms qualified appraisal and qualified appraiser are defined in temporary regulations issued under section 170. In general, a qualified appraiser must be independent with respect to the transaction, must be qualified to appraise the type of property involved, and hold himself out to be qualified as an appraiser.

⁴² H. Rep. No. 861, 98th Cong., 2d Sess. 984-85 (1984), 1984-3 C.B. (Vol. 2) 49, 238-39.

⁴³ Section 6621(c)(a)(A)(i).

⁴⁴ S. Rep. No. 938, 94th Cong., 2d Sess. 355 (1976), 1976-3 C.B. (Vol. 3) 393; Rev. Rul. 80-28, 1980-1 C.B. 304, 305.

⁴⁵ In Rev. Proc. 80-40, 1980-2 C.B. 774, the IRS set forth guidelines for the application of section 6694(a) and listed some of the factors that will be taken into consideration in determining whether this penalty will be applied, including the nature, frequency and materiality of the errors. The IRS stated that it will consider the normal office procedures of the preparer, and clarified that no penalty would generally be asserted if the preparer relied in good faith on information supplied by the taxpayer. But while a preparer is not required to audit or verify information, the preparer is under a duty to make appropriate inquiries and may not ignore the implications of information furnished or known to the preparer. The IRS also published a series of rulings concerning the application of section 6694 to specific fact situations. Rev. Rul. 80-28, supra; Rev. Rul. 80-262, 1980-2 C.B. 375; Rev. Rul. 80-263, 1980 2 C.B. 376; Rev. Rul. 80-264, 1980-2 C.B. 377; Rev. Rul. 80-265, 1980-2 C.B. 378; Rev. Rul. 80-266, 1980-2 C.B. 378.

⁴⁶ Compare section 6676(a) with section 6676(b).

⁴⁷ See, Commissioner v. Asphalt Products Co., supra.

⁴⁸ S. Rep. No. 313, 99th Cong., 2d Sess. 183 (1986), 1986-3 C.B. (Vol. 3) 1, 183.

⁴⁹ While voluntary correction may not be grounds for waiver, it is the experience of some of the Task Force that a voluntary correction of an error is considered in determining whether to assert a penalty or recommend a waiver.